1. P4 Advanced Investment Appraisal

2. 2 Section F: Treasury and Advanced Risk Management Techniques F2. The use of financial derivatives to hedge against forex risk F3. The use of financial derivatives to hedge against interest rate risk Designed to give you the knowledge and application of:

3. 3  Evaluate for a given hedging requirement which of the following is the most appropriate given the nature of the underlying position and the risk exposure: i.forward rate agreements ii.interest rate futures iii.interest rate swaps iv.options on FRAs (caps and collars), interest rate futures and interest rate swaps F3: The use of financial derivatives to hedge against interest rate risk Learning Outcomes

4. 4 Hedging requirement: nature of underlying position & risk exposure Interest rate risk  the risk that the changes in market interest rates might adversely affect a company’s financial condition  immediate impact of a change in interest rates is on a company’s earnings and cash flows  also impacts a bank’s financial condition by affecting its net interest income For a company borrowing money Interest rates Rise Favourable to companies with fixed interest rates Fall Favourable to companies with floating interest rates For a company depositing money Interest rates Rise Favourable to companies with floating interest rates Fall Favourable to companies with fixed interest rates Continued …

5. 5 Objectives of hedging minimise the risk and/or transform the risk from one type into another Considerations in devising hedging strategy  Careful analysis of current situation  Maturity of borrowing or investment that company intends to hedge  Decision-maker should understand principles behind the pricing of derivatives  Size of transaction involved  Amount of option premium  Creditworthiness of company  Cost of hedging should be compared to the possible opportunity lost  Impact of various hedging techniques on financial reporting Continued …

6. 6 Forward rate agreements (FRAs) FRAs  over-the-counter agreement that determines the rate of interest to be paid or received on an obligation at a future date  the cash flow obligations at maturity are calculated on a notional amount and based on the difference between a pre-determined forward rate and the market rate prevailing on that date Hedging interest rate risk using FRAs Interest rate exposure BorrowerDepositor / lender FixedSell FRABuy FRA FloatingBuy FRASell FRA

7. 7 Advantages of FRA No fee/premium required FRA position can be offset FRA is off balance sheet Terms are flexible and can be negotiated Disadvantages of FRA Illiquid & non tradable Subject to counterparty risk Notation of FRATermination date of FRAEnd of contract period Rate for interest calculation 1 v 31 month3 months3 - 1 = 2 months LIBOR 1 v 71 month7 months7 - 1 = 6 months LIBOR 3 v 63 months6 months6 - 3 = 3 months LIBOR 3 v 93 months9 months9 - 3 = 6 months LIBOR 6 v 126 months12 months12 - 6 = 6 months LIBOR 12 v 1812 months18 months18 - 12 = 6 months LIBOR FRA notation and interpretation Refer to Example (page 509)

8. 8 IRF  Futures contract with an interest-bearing instrument as its underlying asset  Used to enter into speculative (or hedge) positions on changes in short-term interest  It’s value is directly related to interest rates Hedging interest rate risk using IRF PositionIR expected toDecision BorrowerRiseSell IRF Depositor / lenderFallBuy IRF Interest rate futures (IRF) Interest period to be hedged Number of futures contracts used to hedge = 3 months Refer to Example (page 511)

9. 9 Interest Rate Swaps (IRS) IRS Agreement whereby two counterparties agree to:  exchange stream of interest payments  based on notional amount of principal  over agreed a period of time Value of interest rate swap = PV of payments counterparty expects to make LESS PV of expected receipts  Value at inception is zero  Value becomes positive for one party and negative for another Features of IRS Translates floating rate to fixed rate & vice versa No exchange of principal repayment obligations Payment obligation calculated using different interest rate for each party Structured as a separate contract Treated as an off balance sheet item Applicable to new and existing borrowings

10. 10 Types of swaps Floating to fixed interest rate swap Used by companies to fix the interest obligation on their floating rate borrowings Benefits of floating to fixed interest rate swap Flexible risk managementIndependent hedge Example Company Bank loan Bank swap Fixed rate Interest rate summary Loan: LIBOR + credit spread Swap: Fixed rate – LIBOR Net interest cost: Fixed rate + credit spread LIBOR LIBOR + credit spread

11. 11 Types of swaps Fixed to floating interest rate swap Allows companies to undertake floating rate exposure Benefits of floating to fixed interest rate swap Immediate cost savingsNo refinancing requirements Example Company Bank loan Bank swap Fixed rate Interest rate summary Loan: Fixed rate Swap: LIBOR+1.00% - fixed rate Net interest cost: LIBOR+1.00% Fixed rate LIBOR + 1%

12. 12 Interest rate options  Option on a notional borrowing or a deposit which guarantees a minimum or a maximum rate of interest for the option holder (called strike price).  Cash settled. Involves payment of premium.  Used to manage interest rate risk exposures Interest rate options Interest rate call option: guarantees the borrower a maximum rate of interest Interest rate put option: guarantees the depositor a minimum rate of interest Types of interest rate options Exchange traded interest rate options American style options, could be exercised at any time  Call option has the right to buy an interest rate future  Put option has the right to sell an interest rate future OTC interest rate options If at the expiry of the option:  LIBOR < agreed strike price, option contract may be allowed to lapse  LIBOR > agreed strike price, company should exercise option Continued …

13. 13 Caps, floors & collars They are OTC interest rate options that enable a company to hold options for a series of consecutive interest periods. 1. Interest rate cap Contract that enables companies with floating rate debt to limit / cap their exposure to rising interest rates. 2. Interest rate floor  Series of European put options (or floorlets) on a specified interest rate (usually LIBOR) that protects the lender against a decline in the floating interest rates.  The buyer of the floor receives money if, on the maturity of any of the floorlets, the fixed reference rate falls below the agreed strike price of the floor. Benefits of cap Interest rate protection for minimal upfront cost Flexibility to benefit from declining floating interest rate Facilitates cash flow planning Continued …

14. 14 3. Interest rate collar Combination of a cap and a floor transacted simultaneously. The buyer of an interest rate cap, purchases an interest rate cap while selling a floor indexed to the same interest rate, for the same amount and covering the same period. Types of interest rate collar Borrowing collar Company buys put option & sells call option Lending collar Company buys call option & sells put option Benefits of collar Buyer receives interest rate protection without any payment upfront Collars can be structured for any term, on any portion of the company’s variable debt Creates certainty on a range of possible interest rates that the company will pay / receive Continued …

15. 15 Swaptions  Hybrid derivative products that integrate the benefits of swaps and options.  Buyer of a swaption has the right, but not the obligation, to enter into interest rate or currency swap during a limited period of time and at a specified rate.  Available on the over-the-counter market  Involves payment of a premium  Can be 'European', exercisable only on the maturity date, or 'American', exercisable on any business day during the exercise period Swaptions Types of swaptions Call swaption Put swaption Gives its holder the right to receive fixed interest payments. It is useful when interest rates are expected to fall. Gives its holder the right to make fixed interest payments. It is useful if interest rates are expected to rise.

16. 16 Recap  Evaluate for a given hedging requirement which of the following is the most appropriate given the nature of the underlying position and the risk exposure: i.forward rate agreements ii.interest rate futures iii.interest rate swaps iv.options on FRAs (caps and collars), interest rate futures and interest rate swaps

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