Fin management materials / 11 P4AFM-Session14_j08

SESSION 14 – INTEREST RATE RISK MANAGEMENT

Example 1

Theakston plc

The corporate treasurer of Theakston has received the company’s financial projections for the next year. The figures show a deficit of £12.2m from 1 March and lasting for 6 months. Today is 1 December. Theakston can borrow at base rate, currently 6%, plus 1.5%.

The treasurer believes that the Bank of England is likely to raise interest rates during the next 3 months in order to cool the economy.

LIFFE prices (1 December)

Futures

LIFFE £500,000 three month sterling interest rate (points of 100%)

Required:

(a)Illustrate the results of a futures hedge if interest rates rise by 2% and futures prices move by 1.8%.

(b)Illustrate the results of an options hedge using the same assumptions.

(c)If the hedge in (b) is too expensive for Theakston what can the company do to reduce the cost?

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6INTEREST RATE SWAPS

Definition

An exchange between two parties of interest obligations or receipts in the same currency on an agreed amount of notional principal for an agreed period of time

6.1Plain vanilla swaps

¾This most common interest rate swap is a plain vanilla swap where fixed interest payments based on a notional principal are swapped for floating interest payments based upon the same notional principal.

¾This is a flexible method for companies to change the interest rate profile of their underlying loans or investments.

¾It can also lead to cheaper finance for both parties.

Illustration 7

(a)A plc wishes to raise $1m fixed interest debt finance. Because of a poor credit rating a debenture issue is not possible and the best fixed interest rate loan it can obtain is at 12.5%. It can, however, borrow at a variable rate of LIBOR + 0.5%.

(b)B plc can issue fixed rate debentures at 11% or alternatively borrow at a variable rate equivalent to LIBOR. B plc wants $1 in floating rate finance.

If A plc and B plc arrange to swap, the following steps might be taken:

(1)A plc borrows $1 million at the variable rate of LIBOR + 0.5%.

(2)B plc borrows $1 million at the fixed rate of 11%.

(3)In the swap agreement A plc agrees to pay B plc interest of 11.75% (fixed) on $1 million, while B plc agrees to pay A plc an interest rate of LIBOR (variable) on the same sum. Note that there is a swap of interest streams, not a swap of principals.

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6.2Advantages of swaps

9Interest rate hedging - over longer periods than available using FRA’s, futures or options.

9Cheaper finance - by borrowing the opposite of the desired type of finance and then swapping into what is required a company can pay less interest compared to directly borrowing what it wants.

9Access to types of finance not directly available – for example some companies are not offered fixed rates by their banks. In this case they can borrow floating rate and use a plain vanilla swap to indirectly obtain fixed rate.

9Flexibility - swaps can be arranged for any sum and over varying time periods, and may be reversed by re-swapping with other counter-parties.

9Low transaction costs - these are limited to the legal fees in agreeing the documentation and arrangement fees.

9Financial engineering - swaps are a fast and convenient method of changing a company’s debt profile. Imagine that the company has issued fixed rate debts and now wishes to move towards floating rate. Without a swap it would be necessary to redeem the exiting debts (possibly triggering large early redemption penalties) and then issue new debts with the related issue costs. However with a swap the company does not need to touch the existing debts and thereby avoids redemption penalties and new issue costs.

6.3Disadvantages of swaps

8Risk of default - to date there have been few publicised defaults on swap contracts. As a result all market participants have been “winners”. In practice swaps are usually arranged via an international bank which acts as the counterparty for each company and hence minimizes default risk.

8Position risk - for example if company has fixed interest debt and swaps into floating rate debt it faces the risk of an unexpected rise in interest rates.

8Transparency risk - historically swaps were off-balance sheet transactions and not dealt with by accounting standards which tend to lag developments in finance. Therefore there was a risk that a company’s finances were not transparent to users of the accounts. Such transparency risk should be falling with the introduction of IAS 39, although how many users of accounts understand the financial reporting for derivatives is questionable.

8Warehousing risk – if the bank does not have a counterparty available it may personally enter into a swap with a client, and then later attempt to re-swap out of the position. During this period this time the bank has changed its own interest rate position which may have adverse consequences. This is known as warehousing risk,

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Example 2

Real plc wishes to raise $15 million of floating rate finance. It has an AAB rating and can issue fixed rate finance at 6.35%, or floating rate at LIBOR plus 60 basis points.

Ale plc has only a BBC credit rating and can raise fixed rate finance at 7.8%, or floating rate at LIBOR + 1.35%.

A five-year interest rate swap on a $15 million loan could be arranged with Golden Sacks Bank acting as an intermediary for a fee of 0.25% per annum, half payable by each party.

Required:

(a)Prove that the swap can benefit both companies.

(b)Design the swap so as to benefit both companies equally.

Solution

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6.4Other types of swap

The most common type of interest rate swap is the plain vanilla. However various “flavoured” swaps are also possible:

¾Amortising swap – the notional principal falls over the life of the swap

¾Accreting swap – the notional principal rises

¾Seasonal swap – the notional principal varies over the year

¾Roller Coaster swap - the notional principal initially rises then amortizes to zero

¾Off market swap – has a NPV an inception (usually swaps start with zero NPV) e.g. the fixed rate in the swap is above market rate, creating negative NPV at inception for the fixed rate payer

¾Forward swap – starts at a future date

¾Extension swap – extends an existing swap

¾Basis swap – based upon two floating rates

¾Yield curve swap – two floating rates referenced to instruments with different maturities

¾Differential swap – referenced to interest rates in different currencies but settled in one currency

6.5Swaptions

Definition

A swaption is an option that provides the holder with the right but not the obligation to execute an interest rate (or a currency swap) during a limited period of time and at a specified rate.

¾Swaptions integrate the benefits of swaps and flexibility of options and are known as “hybrid derivatives”.

¾There are three main types:

American swaptions – can be exercised on any day within the exercise period.

European swaptions – can only be exercised on the expiry date.

Extendable swaptions – allows the company to extend the period of an existing swap.

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Key points

Depending on the nature of its assets and liabilities a firm may be concerned with either rising or falling interest rates.

Practical internal hedges are available such as keeping a balance of exposures between floating and fixed rates on both investments (if practical) and liabilities.

However any residual exposure can be hedged externally using various financial instruments.

Note that when using interest rate derivatives physical delivery is very unusual - contracts are either cash settled (FRA’s, OTC options, swaps) or closed out using offset (futures).

FOCUS

You should now be able to:

¾ describe the nature of interest rate risk;

¾evaluate internal methods of hedging;

¾evaluate the use of FRA’s to provide a short term fixed interest rate;

¾describe the various types of interest rate OTC options and to evaluate their use in hedging strategies;

¾implement hedging strategies using interest rate futures;

¾implement hedging strategies using options on interest rate futures;

¾describe the nature and uses of interest rate swaps;

¾to appreciate the use of options on swaps i.e. swaptions.

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EXAMPLE SOLUTIONS

Solution 1

(a)

The company fears that interest rates will rise, causing extra interest on its forecast borrowing. Therefore it should set up a position on futures that will produce a gain if interest rates rise.

If interest rates rise then futures prices fall. Therefore Theakston should first sell interest rate futures in the expectation that their price will fall.

Assume that the forecast loan will be fixed rate i.e. the interest rate on the loan will be set according to base rate on 1 March and then not reset during its six month life. Therefore the risk for Theakston is that rates rise between 1 December and 1 March,

Hence the hedge needs to be open until 1 March. March or June futures contracts can be used although it is better to use March futures as this reduces the basis risk in the hedge (the March futures will be closed out relatively close to their delivery date which would be towards the end of March)

The notional bill underlying each futures contract has a face value of £500,000 and duration of three months.

If Theakston was borrowing £12.2m for three months it would need 12.2/0.5 = 24.4 futures contracts to protect the loan. However the bank loan is for six months therefore 48.8 futures contracts are required to fully hedge it - round to 49 contracts.

On 1 December Theakston sells 49 March futures at 93.45

On 1 March the company simultaneously takes out the loan and closes the futures position

The additional interest on the loan is 2%

If interest rates rise futures prices fall so the market price of March futures is now 93.45- 1.80 = 91.65.

Tick size 0.01% and therefore tick value = 0.01% × 500,000 × 3/12 = £12.50

Gain on futures = 180 ticks×12.50×49 = £110.250.

Net loss =122,000-110,250 = £11750

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The hedge was not perfectly efficient because the futures price changed by less than the interest rate in the economy. This was due to the fall in the level of basis in the contracts.

(b)

Selling futures today produces a gain on futures if interest rates rise but would lead to loss on futures if rates fall – futures are legally binding contracts and therefore not a flexible method of hedging.

Therefore the company might prefer to have the right, but not the obligation, to sell futures i.e. on 1 December buy puts on futures.

Assume that Theakston wants a cap at today’s base rate i.e. 6%. It therefore buys puts at an exercise price of 100-6 = 94.00

Only March options are available but these can be used to hedge until 1 March - although they would expire at the end of March they are American style and can be exercised at any time until expiry.

The company needs the right to sell 49 futures and therefore buys 49 put options.

March puts at 94.00 cost 1.84. This is a percentage cost based on the standard contract, i.e. 1.84% × £500,000 × 3/12 ×49 = £112,700.

On 1 December the company buys 49 March puts at 94.00 strike price and pays a premium of £112,700

1st March:

The price of a March future is now 91.65 (93.45 - 1.8) which is less than the exercise price of the option so Theakston should exercise the options:

Buying puts on interest rate futures creates an interest rate cap.

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