IR Hedges
Forward Rate Agreements: this is a commitment to a fixed interest rate on a future loan. This is a
tailor-made product and as such it is easy to arrange but can be awkward to cancel. An FRA
guarantees the IR that will be paid at the time of the loan and therefore avoids any downward risk (if
interest rates were to rise). However, there is no upwards potential/opportunity, if IRs were to fall.
FRAs have no secondary market.
An FRA works by the company/customer paying the loan at the market IR at the time of the loan and
they will pay the bank/receive from the bank, the difference between the market IR and the agreed IR.
Futures: these are also contracts on an interest rate. However, the terms, periods and amounts are
all standardised and there is no option to abandon, this does make them cheaper than FRAs. Pricing is
calculated as (100-r). Any loss/gain on buying/selling futures is offset against the IR movement.
Futures remove the downward risk but don’t allow for any upward potential, futures also have a
secondary market. Futures have basis risk.
A futures agreement is a standardised agreement. This is more complicated to set up and often
requires a deposit of cash which can cause liquidity issues.
The closing futures price may have been estimated, based on assumptions, hence the result is not
guaranteed.
Recall 2 steps
1) Calculate the Underlying transaction: amount x IR at time of lending (not at agreement
date). PRO RATE THIS
2) Calculate the Gain/loss (as a %)
(Borrow = Sell now and buy at time of exchange. Lend = buy now and sell at time of
exchange)
Gain/loss % x 3/12 x 500k x no. of contracts
3) NET COST
Swaps: This is only for long term borrowing (up to 30 years). This occurs when companies have been
offered favourable rates in their unpreferred method of borrowing (fixed/floating) so they swap rates.
Risks include:
- default/counterparty risk (the company who they have swapped with does not pay them)
- market risk: adverse movement in IRs (and hence they would have saved money had they not
swapped)
- Transparency risk (risk that the accounts were misleading)
If the question is short term borrowing, state how a swap would not be applicable!
Companies may swap because:
- transaction/admin costs are less than those of other sources of finance. The arrangement fee is also
cheaper than terminating an existing loan and taking out a new one.
- can swap for up to 30 years which is better than other hedging methods such as FRAs, futures and
options which are only for short term loans.
- cheaper finance (better rate than they were offered by the bank) and more preferred rates
(fixed/floating options)
- hedge against adverse movements in IRs.
- Flexible since they are tailor made and reversible
OTC Options: the right but not the obligation to borrow/lend at a future date at an agreed rate.
Therefore, there is a level of flexibility since there is an abandonment option. This level of flexibility
, comes at a cost, options are more expensive. With an OTC option, a premium must be paid up front.
This is paid regardless of whether the option is exercised or abandoned.
Traded Options: These are options on IR futures. The company ends up with an IR no higher than
the guaranteed maximum, however, it could be less (therefore, upside potential).
Traded options have basis risk.
Lend = Call (buy now), Borrow = Put Option (sell now)
1) Underlying transaction: use spot rate/IR at time of exchange (not at time of agreement)
2) Exercise or abandon – recall if it is call option, you buy now (at spot rate at agreement) and
you sell later (at spot rate at exchange).
If it is a put option, you sell now (at spot rate at agreement) and buy later (at spot rate at
time of exchange).
If it is a loss, abandon
Number of contracts
3) Premium. This is paid regardless of whether exercised or abandoned.
For the strike price for premium: Month of exchange (or next month after) but spot rate at
agreement
Reasons for an imperfect hedge:
- Rounding the number of contracts – therefore, an element of risk remains
- Closing out before the expiry date (so the future price may not exactly match the spot rate at
time of closing out). This difference is known as basis risk (where the FTSE price is not the
same as the spot rate).
Factors that affect the time value of options:
1) Time period to expiry: the longer until expiry, the greater the value of the option
2) General level of interest rates: the options value is based on the present value of the
exercise price. Therefore, if interest rates were to rise, the option value would increase.
3) Volatility of market prices of shares: If the volatility of the share price increases, the
probability of the option becoming ‘in the money’ increases and hence, the option value
increases.
Time value = Option Premium – Intrinsic Value
Factors that affect the intrinsic value of options:
1) Exercise price:
Call option: lower the exercise price in relation to the share price, the higher the intrinsic
value and hence the option is more valuable.
Put Option: higher the exercise price in relation to the share price, the higher the intrinsic
value and hence the option is more valuable.
2) Share Price:
Call: as share prices rise, the option becomes deeper in the money and hence the intrinsic
Forward Rate Agreements: this is a commitment to a fixed interest rate on a future loan. This is a
tailor-made product and as such it is easy to arrange but can be awkward to cancel. An FRA
guarantees the IR that will be paid at the time of the loan and therefore avoids any downward risk (if
interest rates were to rise). However, there is no upwards potential/opportunity, if IRs were to fall.
FRAs have no secondary market.
An FRA works by the company/customer paying the loan at the market IR at the time of the loan and
they will pay the bank/receive from the bank, the difference between the market IR and the agreed IR.
Futures: these are also contracts on an interest rate. However, the terms, periods and amounts are
all standardised and there is no option to abandon, this does make them cheaper than FRAs. Pricing is
calculated as (100-r). Any loss/gain on buying/selling futures is offset against the IR movement.
Futures remove the downward risk but don’t allow for any upward potential, futures also have a
secondary market. Futures have basis risk.
A futures agreement is a standardised agreement. This is more complicated to set up and often
requires a deposit of cash which can cause liquidity issues.
The closing futures price may have been estimated, based on assumptions, hence the result is not
guaranteed.
Recall 2 steps
1) Calculate the Underlying transaction: amount x IR at time of lending (not at agreement
date). PRO RATE THIS
2) Calculate the Gain/loss (as a %)
(Borrow = Sell now and buy at time of exchange. Lend = buy now and sell at time of
exchange)
Gain/loss % x 3/12 x 500k x no. of contracts
3) NET COST
Swaps: This is only for long term borrowing (up to 30 years). This occurs when companies have been
offered favourable rates in their unpreferred method of borrowing (fixed/floating) so they swap rates.
Risks include:
- default/counterparty risk (the company who they have swapped with does not pay them)
- market risk: adverse movement in IRs (and hence they would have saved money had they not
swapped)
- Transparency risk (risk that the accounts were misleading)
If the question is short term borrowing, state how a swap would not be applicable!
Companies may swap because:
- transaction/admin costs are less than those of other sources of finance. The arrangement fee is also
cheaper than terminating an existing loan and taking out a new one.
- can swap for up to 30 years which is better than other hedging methods such as FRAs, futures and
options which are only for short term loans.
- cheaper finance (better rate than they were offered by the bank) and more preferred rates
(fixed/floating options)
- hedge against adverse movements in IRs.
- Flexible since they are tailor made and reversible
OTC Options: the right but not the obligation to borrow/lend at a future date at an agreed rate.
Therefore, there is a level of flexibility since there is an abandonment option. This level of flexibility
, comes at a cost, options are more expensive. With an OTC option, a premium must be paid up front.
This is paid regardless of whether the option is exercised or abandoned.
Traded Options: These are options on IR futures. The company ends up with an IR no higher than
the guaranteed maximum, however, it could be less (therefore, upside potential).
Traded options have basis risk.
Lend = Call (buy now), Borrow = Put Option (sell now)
1) Underlying transaction: use spot rate/IR at time of exchange (not at time of agreement)
2) Exercise or abandon – recall if it is call option, you buy now (at spot rate at agreement) and
you sell later (at spot rate at exchange).
If it is a put option, you sell now (at spot rate at agreement) and buy later (at spot rate at
time of exchange).
If it is a loss, abandon
Number of contracts
3) Premium. This is paid regardless of whether exercised or abandoned.
For the strike price for premium: Month of exchange (or next month after) but spot rate at
agreement
Reasons for an imperfect hedge:
- Rounding the number of contracts – therefore, an element of risk remains
- Closing out before the expiry date (so the future price may not exactly match the spot rate at
time of closing out). This difference is known as basis risk (where the FTSE price is not the
same as the spot rate).
Factors that affect the time value of options:
1) Time period to expiry: the longer until expiry, the greater the value of the option
2) General level of interest rates: the options value is based on the present value of the
exercise price. Therefore, if interest rates were to rise, the option value would increase.
3) Volatility of market prices of shares: If the volatility of the share price increases, the
probability of the option becoming ‘in the money’ increases and hence, the option value
increases.
Time value = Option Premium – Intrinsic Value
Factors that affect the intrinsic value of options:
1) Exercise price:
Call option: lower the exercise price in relation to the share price, the higher the intrinsic
value and hence the option is more valuable.
Put Option: higher the exercise price in relation to the share price, the higher the intrinsic
value and hence the option is more valuable.
2) Share Price:
Call: as share prices rise, the option becomes deeper in the money and hence the intrinsic
