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3 Interest rate caps, collars and floors

3 Interest rate caps, collars and floors

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4.4.1 Swap procedures
Interest rate swaps involve two parties agreeing to exchange interest payments with each other over an
agreed period. In practice, however, the major players in the swaps market are banks and many other
types of institution can become involved, for example national and local governments and international
institutions.
In the simplest form of interest rate swap, party A agrees to pay the interest on party B's loan, while party
B reciprocates by paying the interest on A's loan. If the swap is to make sense, the two parties must swap
interest which has different characteristics. Assuming that the interest swapped is in the same currency,
the most common motivation for the swap is to switch from paying floating rate interest to fixed interest
or vice versa. This type of swap is known as a 'plain vanilla' or generic swap.

4.4.2 Why bother to swap?
Obvious questions to ask are:



Why do the companies bother swapping interest payments with each other?
Why don't they just terminate their original loan and take out a new one?

The answer is that transaction costs may be too high. Terminating an original loan early may involve a
significant termination fee and taking out a new loan will involve issue costs. Arranging a swap can be
significantly cheaper, even if a banker is used as an intermediary. Because the banker is simply acting as
an agent on the swap arrangement and has to bear no default risk, the arrangement fee can be kept low.

Exam focus
point

If you have to discuss which instrument should be used to hedge interest rate risk, consider cost,
flexibility, expectations and ability to benefit from favourable interest rate movements.

Part G Risk management  20: Interest rate risk

411

Chapter Roundup


The interest rates on financial assets are influenced by the risk of the assets, the duration of the lending,
and the size of the loan.
There is a trade-off between risk and return. Investors in riskier assets expect to be compensated for the
risk.



Interest rate risk relates to the sensitivity of profit and cash flows to changes in interest rates.
Interest rate risk is faced by companies with floating and fixed rate debt. It can arise from gap exposure
and basis risk.



The causes of interest rate fluctuations include the structure of interest rates and yield curves and
changing economic factors.



Interest rate risk can be managed using internal hedging in the form of asset and liability management,
matching and smoothing or using external hedging instruments, such as forward rate agreements and
interest rate derivatives.



Forward rate agreements hedge risk by fixing the interest rate on future short-term borrowing.



Interest rate derivatives can be used to hedge against the risk of interest rate changes. They include
interest rate futures, interest rate options and interest rate swaps.



Interest rate options allow an organisation to limit its exposure to adverse interest rate movements, while
allowing it to take advantage of favourable interest rate movements.



Caps set a ceiling to the interest rate; a floor sets a lower limit. A collar is the simultaneous purchase of a
cap and sale of floor.



Interest rate swaps are where two parties agree to exchange interest rate payments.
Interest rate swaps can act as a means of switching from paying one type of interest to another, raising
less expensive loans and securing better deposit rates.
A fixed to floating rate currency swap is a combination of a currency and interest rate swap.

Quick Quiz
1

What is LIBOR?

2

Which of the following is not an explanation for a downward slope in the yield curve?
A
B
C
D

Liquidity preference
Expectations theory
Government policy
Market segmentation

3

What is basis risk?

4

How do forward rate agreements hedge risk?

5

Fill in the blanks.
With a collar, the borrower buys (1) ..…........................ and at the same time sells (2) ..............................

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6

What is gap exposure?

7

Name three types of interest rate derivative used to hedge interest rate risk.

20: Interest rate risk  Part G Risk management

Answers to Quick Quiz
1

The rate of interest that applies to wholesale money market lending between London banks

2

A

3

Basis risk is where a company has assets and liabilities of similar sizes, both with floating rates but the
rates are not determined using the same basis.

4

Forward rate agreements hedge risk by fixing the interest rate on future borrowing.

5

(1)
(2)

6

Gap exposure is where a firm is exposed to interest rate risk form differing maturities of interest-sensitive
assets and liabilities.

7

Any three of:

Liquidity preference (and thus compensating investors for a longer period of time) is an
explanation of why the liquidity curve slopes upwards.

(a)
(b)
(c)
(d)

An interest rate cap
An interest rate floor

Futures contracts
Interest rate options
Caps, collars and floors
Interest rate swaps

Now try the questions below from the Practice Question Bank

Number

Level

Marks

Approximate time

Section A Q32

Examination

2

4 mins

Section B Q21-25

Examination

10

20 mins

Section C Q24

Introductory

N/A

39 mins

Part G Risk management  20: Interest rate risk

413

414

20: Interest rate risk  Part G Risk management

Mathematical tables

415

416

Present value of 1 ie (1+r)–n
Where

r = discount rate
n = number of periods until payment

Mathematical tables

417

Annuity Table
Present value of an annuity of ie
Where

418

Mathematical tables

r = discount rate
n = number of periods

Practice question and answer
bank

419

420

Section A questions
1

The following statements relate to various functions within a business.
1
2

The financial management function makes decisions relating to finance.
Financial accounts are used as a future planning tool.

Are the statements true or false?
A
B
C
D
2

Most management accounting information is of a monetary nature
Financial accounts act as a future planning tool
Financial management decisions include dividend decisions
Management accounting is the management of finance

(2 marks)

Which of the following is NOT a connected stakeholder?
A
B
C
D

4

(2 marks)

Which of the following is true?
A
B
C
D

3

Both statements are true
Both statements are false
Statement 1 is true and statement 2 is false
Statement 2 is true and statement 1 is false

Shareholders
Customers
Competitors
Local community

(2 marks)

The following statements relate to fiscal policy and demand management.
1
2

If a government spends more by borrowing more, it will raise demand in the economy.
A government can reduce demand in an economy by raising taxes.

Are the statements true or false?
A
B
C
D
5

Both statements are true
Both statements are false
Statement 1 is true and statement 2 is false
Statement 2 is true and statement 1 is false

(2 marks)

The following statements relate to business and the economic environment.
1
2

To create jobs and growth, there must be an increase in aggregate demand.
High interest rates encourage companies to make investments.

Are the statements true or false?
A
B
C
D
6

Both statements are true
Both statements are false
Statement 1 is true and statement 2 is false
Statement 2 is true and statement 1 is false

(2 marks)

The following statements relate to business and the economic environment.
1

Raising taxes or reducing government spending is a contractionary policy.

2

Fiscal policy seeks to influence the economy by managing government spending and
taxation.

Are the statements true or false?
A
B
C
D

8

Both statements are true
Both statements are false
Statement 1 is true and statement 2 is false
Statement 2 is true and statement 1 is false

(2 marks)

Practice question bank

421