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INTEREST RATE & RISK MANAGEMENT

The document discusses interest rate risk and its impact on profits and cash flows, detailing rate exposure and gap analysis. It explains different types of yield curves and theories related to them, as well as strategies for managing interest rate risk, including forward rate agreements and interest rate options. Additionally, it covers interest rate futures and guarantees, highlighting their roles in hedging against interest rate fluctuations.

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astel0973
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8 views

INTEREST RATE & RISK MANAGEMENT

The document discusses interest rate risk and its impact on profits and cash flows, detailing rate exposure and gap analysis. It explains different types of yield curves and theories related to them, as well as strategies for managing interest rate risk, including forward rate agreements and interest rate options. Additionally, it covers interest rate futures and guarantees, highlighting their roles in hedging against interest rate fluctuations.

Uploaded by

astel0973
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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INTEREST RATE & RISK MANAGEMENT – BY AJAY

SHARMA (THEACCASIST®️)

1) INTEREST RATE RISK


Sensitivity of Profits & Cash flows to change in Interest rates .
2) RATE EXPOSURE
Risk of an, adverse movement in Interest rate and a reduction in Net
cash flows.
• GAP EXPOSURE
How much % or degree the company is exposed to Interest rate Risk, can be
Identified by GAP ANALYSIS
There are two types of Gaps
1) POSTIVE GAP
This occurs when Interest sensitive assets are more than Interest
Sensitive liabilities
2) NEGATIVE GAP
This occurs when, Interest sensitive Liabilities are more than Interest
Sensitive assets.
3) YIELD CURVE
There are three types of yield curve
A) Normal yield curve
The above figure shows Normal yield curve ,which is upward
sloping, results high yield on Long-term maturity, here short term
interest rates are lower than Long-term Interest rates.. Occurs
during a boom period
B) Flat yield curve .

Flat yield curve seen when yield on long term and short term bond is equal
yield for bond with various maturity period is same Occurs when there is a
Economic uncertainty, expectation that a cut in rates in future or when in
transition period from boom to recession

C) Inverted yield curve


This occurs when yield on short term bond is higher than the
yield on long term bond. Occurs during recession or tight
monetary policy by Government leads to increased uncertainty
in investors and reduced Borrowing.

2
Below figure illustrates Inverted yield curve

THEORIES ON YIELD CURVE.


1) LIQUIDITY PREFERENCE THEORY
Liquidity Preference Theory states that investors demand higher
returns for less liquid bonds, driving interest rates up for longer-term
bonds. Investors prioritize liquidity, seeking cash or short-term bonds,
and require compensation for tying up funds in longer-term

2) EXPECTATIONS THEORY.
States that shape of yield curve reflects expectations of the investors
about inflation and Interest rate .

3) MARKET SEGMENTATION THEORY.


States that there is no relationship between long term interest rates
and short term interest rates.
Thus there are two separate debt markets, investors are segmented
into group.
Short term rates are determined by demand and supply of short term
debt, and same for long term.

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How to Manage the Interest Rate Risk????
1) Smoothing: This Involves maintaining proper Balance between
fixed rate & floating rate deposits or Borrowing
2) Matching : This states that we should have common interest rate
for our assets & liabilities.
3) FORWARD RATE AGREEMENT ( FRAS)

FRA FIXES INTEREST RATE ,Now for a future short term lending
FRAs are cash settled. Agreement either with a bank or a financial
institution. It is customized agreement, can be tailored as per
demands hence an OTC, Over the counter option. No premium or
deposit to be paid for FRA.

Example :

Sharma & Textiles plans to borrow $30m in three months for six
months and wishes to pay 7% interest no matter what happens to
interest rates during the next three months. It can enter into an
FRA with the bank at an agreed rate of 7% on principal amount of
30M.
Solution
As Sharma & Textiles plans to borrow 30m I’m three months for 6
months , so this means agreement Starting in three months and
lasting for six months. This is known as a 3-9 FRA because it begins
in 3 months and ends after 9 months.
The main thing is,
If the ACTUAL INTEREST RATE > THE RATE AGREED IN FRA , then
BANK WILL PAY TO SHARMA & TEXTILES the difference amount
between both rates.
If the ACTUAL RATE < RATE AGREED IN FRA, then SHARMA &
TEXTILES WILL PAY TO BANK, the difference amount between both
rates.

4
INTEREST RATE FUTURES.
Exchange traded Contracts ( ETD) whose value is ascertained by interest
rates.
The future contract Gives right to owner to earn interest or obligation to pay
interest.
For incase of BORROWING : SELL FUTURES NOW and buy them back on
close out
For incase of DEPOSIT : BUY FUTURES NOW and sell them on close out.
Basis risk : The difference between the interest rate in Futures contract and
spot interest rate is referred as basis in Futures contract
INTREST RATE GURANTEES(IRGs)
An IRG is an Option over FRA, to Lapse or Exercise .
If it is an adverse movement for us, then let it LAPSE
If it is Favourable movement for us , then EXERCISE IT.
IRGs are expensive
Example.
FRA HAS 8% RATE, WHEREAS THE ACTUAL PREVAILING RATE IS 12%
In this situation, this is favourable to us as Market Rate is more than FRA ,
Exercise the option and PAY loss to bank.
[Jis bhi party ko adverse movement hoga , vo FRA maim ayega]
For bank loss is , market main zyada rate milna
For company loss is , market Rate Kam hona FRA se.

INTEREST RATE OPTIONS(OTC)


Gives the holder the right, but not the obligation, to lend or borrow at a
specified interest rate.
2. Provide flexibility and protection against interest rate fluctuations.

5
3. Can be used to hedge or speculate on Interest rate
An interest rate option protects the holder against adverse rate movements
and allows them to benefit from favourable movements.
On the expiry date, the buyer has to decide whether to exercise the right.
Borrowers can set a maximum on the interest they have to pay by buying put
options
Lenders/depositors can set a minimum on the interest they receive by buying
call options.
THREE TYPES OF OPTIONS .
1) Interest Rate Cap: Limits how high interest rates can go , protects
against high interest rates, sets a maximum interest rate .Holder has
to pay premium .
2) Interest Rate Floor: Ensures interest rates don’t fall below a set rate,
protects against falling interest rates. Sets a minimum interest rate .
Holder will get payment if the rate falls below floor.
3) Interest Rate Swap: Trades fixed interest for variable interests , HERE
TWO PARTIES EXCHANGE INTEREST PAYMENTS ONLY NOT PRINCIPAL ,
No Premium involved.

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