Risk

Management

Exchange rate
An exchange rate is the rate at which one country’s currency can be traded
in exchange for another country’s currency.

The spot rate is the exchange rate currently offered on a particular currency
for immediate delivery.

A forward rate is an exchange rate set now for currencies to be exchanged at

a future date

Direct and indirect currency quotes

Direct quote is the amount of domestic currency, which is equal to one
foreign currency unit.

Indirect quote is the amount of foreign currency, which is equal to one

domestic currency unit

In U.K indirect quote is invariably used but in the rest of the world it is mostly
direct quote

If a currency is quoted at $1.500: £1, the $ is the counter currency (the

reference or term currency), the £ is the base currency

Bid and Offer

The bid price is the rate at which the bank is willing to buy the currency

The offer (or ask) price is the rate at which the bank is willing to sell the
currency

The rule is that banks buy (currency) high and sells low

Test your understanding 1

Calculate how much sterling exporters would receive or how much sterling
importers would pay, ignoring the bank's commission, in each of the following
situations, if they were to exchange currency and sterling at the spot rate.

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Management a)
A
UK exporter receives a payment from a Danish customer of 150,000
kroner.
b) A UK importer buys goods from a Japanese supplier and pays 1 million
yen.

Spot rates are as follows

Bank sells (offer) Bank buys (bid)

Danish kr/£ 9.4340 - 9.5380

Japan ¥/£ 168.650 - 170.781

Test your understanding 2

The US$ rate per £ is quoted as 1.4325 – 1.4330.

Company A wants to buy $100,000 in exchange for sterling.

Company B wants to sell $200,000 in exchange for sterling.

What rate will the bank offer each company?

Test your understanding 3

The current euro / US dollar exchange rate is €1: $2. ABC Co, a Eurozone
company, makes a $1,000 sale to a US customer on credit. By the time the
customer pays, the Euro has strengthened by 20%.

What will the Euro receipt be?

A. €416.67
B. €2,400
C. €600
D. €400

Foreign currency risk

Currency risk is the risk of changes in an exchange rate or in the foreign
exchange value of a currency. It is a two-way risk.

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Currency risk occurs in three forms: transaction exposure (short-term),
economic exposure (effect on present value of longer-term cash flows) and
translation exposure (book gains or losses).

Translation risk
Translation risk is the risk that the organisation will make exchange losses
when the accounting results of its foreign branches or subsidiaries are
translated into the home currency.
Translation losses can result, for example, from re-stating the book value of a
foreign subsidiary's assets at the exchange rate on the statement of financial
position date.

The effect of translation risk is to create gains or losses in the reported

financial results of the parent group, but they do not create cash flow gains
or losses.

Transaction risk
Transaction risk is the risk of an exchange rate changing between the
transaction date and the subsequent settlement date, i.e. it is the gain or loss
arising on conversion.
It arises on any future transaction involving conversion between two
currencies (for example, if a UK company were to invest in USD bonds, the
interest receipts would be subject to transaction risk). The most common area
where transaction risk is experienced relates to imports and exports.

Economic risk
This refers to the effect of exchange rate movements on the international
competitiveness of a company and refers to the effect on the present value of
longer-term cash flows.

It is the risk that over time a currency will depreciate or appreciate in value
against other currencies, so that a country's economy becomes more or less
competitive.

For example, a UK company might use raw materials, which are priced in US
dollars, but export its products mainly within the EU, pricing its exports in
sterling. A depreciation of sterling against the dollar or an appreciation of
sterling against other EU currencies will erode the competitiveness of the
company.

Economic exposure can be difficult to avoid, although diversification of the

supplier and customer base across different countries will reduce this kind of
exposure to risk.

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Test your understanding 4
Exporters Co is concerned that the cash received from overseas sales will not
be as expected due to exchange rate movements.

What type of risk is this?

A. Translation risk
B. Economic risk
C. Rate risk
D. Transaction risk

Test your understanding 5

Bulldog Ltd, a UK company, buys goods from Redland, which cost 100,000
Reds (the local currency). The goods are resold in the UK for £32,000. At the
time of the import purchase the exchange rate for Reds against sterling is
Red3.5650 – Red3.5800 per £1.
Required
a) What is the expected profit on the resale?
b) What would the actual profit be if the spot rate at the time when the
currency is received has moved to:

I. Red3.0800 – Red3.0950 per £1?

II. Red4.0650 – Red4.0800 per £1?

Ignore bank commission charges.

The causes of exchange rate fluctuations

Factors influencing the exchange rate include the comparative rates of
inflation in different countries (purchasing power parity), comparative
interest rates in different countries (interest rate parity), the underlying
balance of payments, speculation and government policy on managing or
fixing exchange rates.
The exchange rate between two currencies – ie the buying and selling rates,
both spot and forward – is determined primarily by supply and demand in the
foreign exchange markets. Demand comes from individuals, firms and
governments who want to buy a currency. Supply comes from those who want
to sell it.

Supply and demand for currencies are in turn influenced by:

 The rate of inflation, compared with the rate of inflation in other

countries
 Interest rates, compared with interest rates in other countries
 The balance of payments in goods and services

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Management
 Transactions of a capital nature, such as inward or outward foreign
investment
 Sentiment of foreign exchange market participants regarding economic
prospects
 Speculation
 Government policy on intervention to influence the exchange rate

Interest rate parity

Interest rate parity is a method of predicting foreign exchange rates based on
the hypothesis that the difference between the interest rates in the two
countries should offset the difference between the spot rates and the forward
foreign exchange rates over the same period.

The difference between spot and forward rates reflects differences in interest
rates.

i.e. The expected dollar return on dollar deposits is equal to the expected
dollar return on foreign deposits.

F0 = S0 × (1+ic)
––––––
(1+ib)

S0 = Current spot

F0 = Forward rate

ib = Interest rate in country C (counter country) up to the future date

ic = Interest rate in country b (the base country) up to the future date

This formula is given to you in the exam.

Test your understanding 6

A Canadian company is expecting to receive Kuwaiti dinars in one year's time.
The spot rate is Canadian dollar 5.4670 per 1 dinar. The company could
borrow in dinars at 9% or in Canadian dollars at 14%. There is no forward rate
for one year's time. Predict what the exchange rate is likely to be in one year.

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Test your understanding 7
A company from Northland is expecting to receive Southland Krone in one
year's time. The spot rate is Northland dollar 3.4670 per 1 Krone. The
company could borrow in Krone at 8% or in Northland dollars at 13%. There is
no forward rate for one year's time.

What would interest rate parity predict the exchange rate to be in one year?

Test your understanding 8

The current spot rate for the US$ to the European € is $2: €1. Annual interest
rates in the two countries are 8% in the US, and 4% in Europe.

What is the 3 months forward rate (to 4 decimal places) likely to be?

A. $1.9804: €1
B. $2.0198: €1
C. $1.9259: €1
D. $2.0769: €1

Purchasing Power Parity Theory (PPPT)

Purchasing power parity theory states that the exchange rate between two
currencies is the same in equilibrium when the purchasing power of currency
is the same in each country.

PPPT claims that the rate of exchange between two currencies depends on
the relative inflation rates within the respective countries.

Rule: PPPT predicts that the country with the higher inflation will be subject to
a depreciation of its currency.

If you need to estimate the expected future spot rates, simply apply the
following formula:

S1 = S0 × (1+hc)
––––––
(1+hb)

Where:

S0 = Current spot

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S1 = Expected future spot

hb = Inflation rate in country for which the spot is quoted (base currency)

hc = Inflation rate in the other country. (Counter currency)

This formula is given to you in the exam.

Note. The expected future spot rate will not necessarily coincide with the
'forward exchange rate' currently quoted.

Test your understanding 9

Dollar and sterling are currently trading at $1.72/£.

Inflation in the US is expected to grow at 3% pa, but at 4% pa in the UK.
Predict the future spot rate in a year’s time.

Test your understanding 10

What does purchasing power parity refers to?

A. A situation where two businesses have equal available funds to spend.

B. Inflation in different locations is the same.
C. Prices are the same to different customers in an economy.
D. Exchange rate movements will absorb inflation differences.

Expectations theory
The expectations theory claims that the current forward rate is an unbiased
predictor of the spot rate at that point in the future. If a trader takes the view
that the forward rate is lower than the expected future spot price; there is an
incentive to buy forward. The buying pressure on the forward raises the price,
until the forward price equals the market consensus view on the expected
future spot price.

Four-way equivalence
The four-way equivalence model states that in equilibrium, differences
between forward and spot rates, differences in interest rates, expected
differences in inflation rates and expected changes in spot rates are equal to
one another.

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Foreign currency risk management

Foreign currency risk can be managed, in order to reduce or eliminate the

risk. Measures to reduce currency risk are known as 'hedging'.

Basic methods of hedging risk include

 Do nothing
 Matching receipts and payments
 Invoicing in own currency
 Leading and lagging the times that cash is received and paid.
 Forward exchange contracts
 Money market hedging.

Do nothing
In the long run, the company would ‘win some, lose some’. This method:
 works for small occasional transactions
 saves in transaction costs
 is dangerous!

Matching receipts and payments

A company may be able to reduce or eliminate its foreign exchange
transaction exposure by matching receipts and payments in a foreign
currency. Wherever possible, a company that expects to make payments and
have receipts in the same foreign currency should plan to offset its payments
against its receipts in the currency.

A company, which has a long-term foreign investment, for example an

overseas subsidiary, may also try to match its foreign assets (property, plant,

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Management
etc) by a long-term loan in the foreign currency. This would reduce its risk
from translation exposure.

The process of matching receipts and payments is made possible by having

one or more foreign currency accounts with a bank. Receipts of the foreign
currency can be paid into the account, and payments made from the account.

Test your understanding 11

What does the term ‘matching’ refer to?

A. The coupling of two simple financial instruments to create a more

complex one
B. The mechanism whereby a company balances its foreign currency
inflows and outflows
C. The adjustment of credit terms between companies
D. Contracts not yet offset by futures contracts or fulfilled by delivery

Invoicing in your own currency

One way of avoiding exchange risk is for exporters to invoice their foreign
customer in their domestic currency, or for importers to arrange with their
foreign supplier to be invoiced in their domestic currency. However, although
either the exporter or the importer can avoid the transaction risk through
invoicing in domestic currency, only one of them can do it.

a) There is the possible marketing advantage by proposing to invoice in the

buyer's own currency, when there is competition for the sales contract.

b) The exporter may also be able to offset payments to their own suppliers in
a particular foreign currency against receipts in that currency.

c) By arranging to sell goods to customers in a foreign currency, an exporter

might be able to obtain a loan in that currency, and at the same time
obtain cover against exchange risks by arranging to repay the loan out of
the proceeds from the sales in that currency.

Leading and lagging

In order to take advantage of foreign exchange rate movements, companies
might try to use:

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Management
Lead payments (payments in advance for goods purchased in a foreign
currency)

Lagged payments (delaying payments beyond their due date for goods
purchased in a foreign currency)

Payments in a foreign currency may be made in advance when the company

expects the foreign currency to increase in value up to the settlement date for
the transaction.
With a lead payment, paying in advance of the due date, there is a finance
cost to consider. This is the interest cost on the money used to make the
payment, but early settlement discounts may be available.

Payments in a foreign currency may be delayed until after the due settlement
date when it is expected that the currency will soon fall in value. However,
delaying payments and taking more than the agreed amount of credit is
questionable business practice.

Netting
Netting is a process in which credit balances are netted off against debit
balances so that only the reduced net amounts remain due to be paid by
actual currency flows.

Forward exchange contracts

A forward exchange contract is defined as:
a) An immediately firm and binding contract, eg between a bank and its
customer
b) For the purchase or sale of a specified quantity of a stated foreign
currency
c) At a rate of exchange fixed at the time the contract is made
d) For performance (delivery of the currency and payment for it) at a future
time which is agreed when making the contract (This future time will be
either a specified date, or any time between two specified dates.)

The purpose of a forward contract is to fix an exchange rate now for the
settlement of a transaction at a future date. This removes uncertainty about
what the exchange rate will be at the future date.

Forward exchange rates

Forward exchange rates are determined by the current spot rate and
differences in interest rates between the two currencies.

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A forward exchange rate may be higher or lower than the spot rate. When a
currency is more expensive forward than spot, it is quoted forward 'at a
premium' to the spot rate. When a currency is cheaper forward than spot, it is
quoted forward 'at a discount' to the spot rate.

Test your understanding 12 – Hedging with forwards

The current spot rate for US dollars against UK sterling is 1.4525 – 1.4535 $/£
and the onemonth forward rate is quoted as 1.4550 – 1.4565.
A UK exporter expects to receive $400,000 in one month.
If a forward exchange contract is used, how much will be received in sterling?

Test your understanding 13

The current spot rate for the US dollar /euro is $/€ 2.0000 +/- 0.003. The dollar
is quoted at a 0.2c premium for the forward rate.

What will a $2,000 receipt be translated to at the forward rate?

A. €4,002
B. €999.5
C. €998
D. €4,008

Test your understanding 14

Which are true of forward contracts?

1. They fix the rate for a future transaction.

2. They are a binding contract.
3. They are flexible once agreed.
4. They are traded openly.

A. 1,2 and 4 only

B. 1,2,3 and 4
C. 1 and 2 only
D. 2 only

Money market hedge

Money market hedging involves borrowing in one currency, converting the
money borrowed into another currency and putting the money on deposit until
the time the transaction is completed, hoping to take advantage of favourable
exchange rate movements.

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Setting up a money market hedge for a foreign currency payment
Suppose a British company needs to pay a supplier in Swiss francs in three
months' time. It does not have enough cash to pay now, but will do in three
months' time. Instead of negotiating a forward contract, the company could:

Step 1 Borrow the appropriate amount in sterling now.

Step 2 Convert the sterling to francs immediately at the spot rate

Step 3 Put the francs on deposit in a Swiss franc bank account.

Step 4 When the time comes to pay the company:

a. Pay the supplier out of the franc bank account.
b. Repay the sterling loan.

Test your understanding 15: Money market hedge

A UK company owes a Danish supplier Kr3,500,000 which is payable in three
months' time. The spot exchange rate is Kr7.5509 – Kr7.5548 per £1. The
company can borrow in sterling for three months at 8.60% per annum and can
deposit kroner for three months at 10% per annum. What is the cost in
pounds with a money market hedge and what effective forward rate would this
represent?

Setting up a money market hedge for a foreign currency receipt

A similar technique can be used to cover a foreign currency receipt from a
trade receivable. To manufacture a forward exchange rate, follow the steps
below.
Step 1 Borrow an appropriate amount in the foreign currency today

Step 2 Convert it immediately to home currency at the spot rate

Step 3 Place this on deposit in the home currency.

Step 4 When the receivable's cash is received:

a. Repay the foreign currency loan.
b. Take the cash from the home currency deposit account.

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Test your understanding 16
A UK company is owed SFr 2,500,000, receivable in 3 months' time from a
Swiss company. The spot exchange rate is SFr1.4498 – SFr1.4510 per £1.
The company can deposit in sterling for 3 months at 8.00% per annum and
can borrow Swiss francs for 3 months at 7.00% per annum. What is the
receipt in sterling with a money market hedge and what effective forward rate
would this represent?

Test your understanding 17

Co is a medium-sized company whose ordinary shares are all owned by the
members of one family. The domestic currency is the dollar. It has recently
begun exporting to a European country and expects to receive €500,000 in six
months' time. The company plans to take action to hedge the exchange rate
risk arising from its European exports.

Ziggazigto Co could put cash on deposit in the European country at an annual

interest rate of 3% per year, and borrow at 5% per year. The company could
put cash on deposit in its home country at an annual interest rate of 4% per
year, and borrow at 6% per year. Inflation in the European country is 3% per
year, while inflation in the home country of Ziggazigto Co is 4.5% per year.

The following exchange rates are currently available to Ziggazigto Co:

Current spot exchange rate € 2.000 per $

Six-month forward exchange rate €1.990 per $
One-year forward exchange rate €1.981 per $

Required
a) Calculate whether a forward exchange contract or a money market hedge
would be financially preferred by Ziggazigto Co to hedge its future euro
receipt. (5 marks)
b) Calculate the one-year expected (future) spot rate predicted by purchasing
power parity theory and explain briefly the relationship between the
expected (future) spot rate and the current forward exchange rate.
c) Explain how inflation rates can be used to forecast exchange rates.

Test your understanding 18

Edted plc has to pay a Spanish supplier 100,000 euro in three months’ time.
The company’s Finance Director wishes to avoid exchange rate exposure,
and is looking at four options.
1. Do nothing for three months and then buy euros at the spot rate
2. Pay in full now, buying euros at today’s spot rate
3. Buy euros now, put them on deposit for three months, and pay the debt

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with these euros plus accumulated interest
4. Arrange a forward exchange contract to buy the euros in three months’
time

Which of these options would provide cover against the exchange rate
exposure that Edted would otherwise suffer?

A. Option (4) only

B. Options (3) and (4) only
C. Options (2), (3) and (4) only
D. Options (1), (2), (3) and (4)

Foreign currency derivatives

Foreign currency derivatives can be used to hedge foreign currency risk.
Futures contract, option and swaps are type of derivatives

Currency futures

A futures market is an exchange-traded market for the purchase or sale of a

standard quantity of an underlying item, such as currencies, commodities or
shares, for settlement at a future date and at an agreed price.

The contract size is the fixed minimum quantity of commodity, which can be
bought or sold using a futures contract. In general, dealing on futures markets
must be in a whole number of contracts.

The contract price is the price at which the futures contract can be bought or
sold. For all currency futures the contract price is in US dollars. The contract
price is the figure, which is traded on the futures exchange. It changes
continuously and is the basis for computing gains or losses.

The settlement date (or delivery date, or expiry date) is the date when trading
on a particular futures contract stops and all accounts are settled. On the
International Monetary Market (IMM), the settlement dates for all currency
futures are at the end of March, June, September and December.

A future's price may be different from the spot price, and this difference is the
basis.
Basis = Spot price – Futures price

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One tick is the smallest measured movement in the contract price. For
currency futures this is a movement in the fourth decimal place.
Market traders will compute gains or losses on their futures positions by
reference to the number of ticks by which the contract price has moved.

Advantages of futures
a) Transaction costs should be lower than other hedging methods.
b) Futures are tradeable and can be bought and sold on a secondary market
so there is pricing transparency, unlike forward contracts where prices are
set by financial institutions.
c) The exact date of receipt or payment of the currency does not have to be
known, because the futures contract does not have to be closed out until
the actual cash receipt or payment is made.

Disadvantages of futures
a) The contracts cannot be tailored to the user's exact requirements.
b) Hedge inefficiencies are caused by having to deal in a whole number of
contracts and by basis risk (the risk that the futures contract price may
move by a different amount from the price of the underlying currency or
commodity).
c) Only a limited number of currencies are the subject of futures contracts
(although the number of currencies is growing, especially with the rapid
development of Asian economies).
d) Unlike options (see below), they do not allow a company to take
advantage of favourable currency movements.

Test your understanding 19

In comparison to forward contracts, which of the following are true in relation
to futures contracts?

1. They are more expensive.

2. They are only available in a small amount of currencies.
3. They are less flexible.
4. They may be an imprecise match for the underlying transaction.

A. 1, 2 and 4 only
B. 2 and 4 only
C. 1 and 3 only
D. 1, 2, 3 and 4

Test your understanding 20

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The difference between the price of a futures contract and the spot price on a
given date is known as:

A. The initial margin

B. Basis
C. Hedge efficiency
D. The premium

Currency option
A currency option is a right of an option holder to buy (call) or sell (put) a
quantity of one currency in exchange for another, at a specific exchange rate
(the exercise rate, exercise price or strike price) on or before a future expiry
date. If a buyer exercises the option, the option seller must sell or buy at this
rate. If an option is not exercised, it lapses at the expiry date.

The exercise price for the option may be the same as the current spot rate, or
it may be more favourable or less favourable to the option holder than the
current spot rate.
Companies can choose whether to buy:

a) A tailor-made currency option from a bank, suited to the company's

specific needs. These are over the counter (OTC) or negotiated options; or

b) A standard option, in certain currencies only, from an options exchange.

Such options are traded or exchange-traded options.

However, buying a currency option involves paying a premium to the option

seller. The option premium is a cost of using an option.

The purposes of currency options

The purpose of currency options is to reduce or eliminate exposure to
currency risks, and they are particularly useful for companies in the following
situations.

1.Where there is uncertainty about foreign currency receipts or payments,

either in timing or amount.
2.To support the tender for an overseas contract by a company, priced in a
foreign currency.
3.To allow the publication of price lists for its goods in a foreign currency. A
company can arrange a number of currency options to sell a quantity of
the foreign currency in exchange for its domestic currency, covering the

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time period for which the price list remains valid.

Drawbacks of currency options

a) They have a cost (the 'option premium'). The cost depends on the
expected volatility of the exchange rate, the choice of exercise rate and
the length of time to the expiry date for the option.
b) Options must be paid for as soon as they are bought.
c) Tailor-made options (arranged over the counter with a bank) lack
negotiability.
d) Traded options are not available in every currency.

Test your understanding 21

The following options are held by Frances plc at their expiry date:

1. A call option on £500,000 in exchange for US$ at an exercise price of

£1 = $1.90. The exchange rate at the expiry date is £1 = $1.95.
2. A put option on £400,000 in exchange for Singapore $ at an exercise
price of £1 = $2.90. The exchange rate at the expiry date is £1 = $2.95.

Test your understanding 22

The put option gives
A. The right to sell an asset at a fixed price
B. An obligation to sell an asset at a fixed price
C. The right to buy an asset at a fixed price
D. An obligation to buy an asset at a fixed price

Test your understanding 23

Nedwen Co is a UK-based company, which has the following expected
transactions.

One month: Expected receipt of $240,000

One month: Expected payment of $140,000
Three months: Expected receipts of $300,000

The finance manager has collected the following information:

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Per £1
Spot rate: $1.7820 ± 0.0002
One month forward rate: $1.7829 ± 0.0003
Three-month forward rate: $1.7846 ± 0.0004

Money market rates for Nedwen Co:

Borrowing Deposit
One-year sterling interest rate: 4.9% 4.6%
One-year dollar interest rate: 5.4% 5.1%

Assume that it is now 1 April.

Required
a) Calculate the expected sterling receipts in one month and in three months
using the forward market.
b) Calculate the expected sterling receipts in three months using a money-
market hedge and recommend whether a forward market hedge or a
money market hedge should be used. (5 marks)
c) Briefly discuss the main features of currency futures contracts.

Test your understanding 24

Expo Co is an importer/exporter of textiles and textile machinery. It is based in
the US but trades extensively with countries throughout Europe. The company
is about to invoice a European customer for €750,000, payable in three
months' time. Expo's treasurer is considering two methods of hedging the
exchange risk. These are:

Method 1: Borrow Euros now, converting the loan into dollars and repaying
the Euro loan from the expected receipt in three months' time.

Method 2: Enter into a 3-month forward exchange contract with the company's
bank to sell €750,000.

The spot rate of exchange is €0.7834 = $1. The 3-month forward rate of
exchange is €0.7688 = $1. Annual interest rates for 3 months' borrowing in:
Euros is 3% for investing in dollars, 5%.

Required

a) Advise the treasurer on:

I. Which of the two methods is the most financially advantageous for

Expo, and

II. The factors to consider before deciding whether to hedge the risk using
the foreign currency marketsInclude relevant calculations in your
advice.

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b)
Advice the treasurer on other methods to hedge exchange rate risk.

Test your understanding 25

Robin Co expects to receive €800,000 from a credit customer in the European

Union in six months’ time. The spot exchange rate is €2.413 per $1 and the
six month forward rate is €2.476 per $1. The following commercial interest
rates are available to Robin Co:

Deposit rate Borrow rate

Euros 3.0% per year 7.0% per year

Dollars 1.0% per year 2.5% per year

Robin Co does not have any surplus cash to use in hedging the future euro
receipt.

1. What could Robin Co do to reduce the risk of the euro value dropping
relative to the dollar before the €800,000 is received?

1) Deposit €800,000 immediately

2) Enter into a forward contract to sell €800,000 in six months
3) Enter into an interest rate swap for six months

A. 1 or 2 only
B. 2 only
C. 3 only
D. 1, 2 or 3

2. What is the dollar value of a forward market hedge?

3. If Robin Co used a money market hedge, what would be the percentage-

borrowing rate for the period?

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Exam guide
The material in this chapter, if it appears in a Section B question, will be
examined almost entirely as a discussion question. It is important that you
understand and can explain the terminology.

Interest rate
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

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.

Interest rate risk is the risk of a change in interest rates, and the effect that
this will have on profits and cash flows. This type of risk is greatest for
organisations with large amounts of assets that yield interest or liabilities on
which interest is payable. Banks and investment institutions are therefore
heavily exposed to interest rate risk, but so too are companies with large
borrowings.

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Gap exposure
The degree to which a firm is exposed to interest rate risk can be identified by
using the method of gap analysis. Gap analysis is based on the principle of
grouping together assets and liabilities, which are sensitive to interest rate
changes according to their maturity dates. Two different types of 'gap' may
occur.
a) A negative gap
A negative gap occurs when a firm has a larger amount of interest-sensitive
liabilities maturing at a certain time or in a certain period than it has interest
sensitive assets maturing at the same time. The difference between the two
amounts indicates the net exposure.

b) A positive gap
There is a positive gap if the amount of interest-sensitive assets maturing at a
particular time exceeds the amount of interest-sensitive liabilities maturing at
the same time.

With a negative gap, the company faces exposure if interest rates rise by the
time of maturity. With a positive gap, the company will lose out if interest rates
fall by maturity.

The causes of interest rate fluctuations

The yield curve

The term structure of interest rates refers to the way in which the yield (return)
of a debt security or bond varies according to the term of the security, i.e. to
the length of time before the borrowing will be repaid.

The yield curve is an analysis of the relationship between the yields on debt
with different periods to maturity.

A yield curve can have any shape, and can fluctuate up and down for different
maturities.
There are three main types of yield curve shapes: normal, inverted and flat (or
humped):

 Normal yield curve – longer maturity bonds have a higher yield compared
with shorter-term bonds due to the risks associated with time
 Inverted yield curve – the shorter-term yields are higher than the longer
term yields, which can be a sign of upcoming recession
 flat (or humped) yield curve – the shorter and longer-term yields are very
close to each other, which is also a predictor of an economic transition.

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The slope of the yield curve is also seen as important: the greater the slope,
the greater the gap between short and long-term rates.

The shape of the yield curve at any point in time is the result of the three
following theories acting together:
 Liquidity preference theory
 Expectations theory
 Market segmentation theory.

Liquidity preference theory

Investors have a natural preference for more liquid (shorter maturity)
investments. They will need to be compensated if they are deprived of cash
for a longer period.

Expectations theory
The normal upward sloping yield curve reflects the expectation that inflation
levels, and therefore interest rates will increase in the future.

Market segmentation theory

The market segmentation theory suggests that there are different players in
the short-term end of the market and the long-term end of the market.
The yield curve is therefore shaped according to the supply and demand of
securities within each maturity length.

Hedging interest rate risk

Forward rate agreements (FRAs)
The aim of an FRA is to:
 lock the company into a target interest rate
 hedge both adverse and favourable interest rate movements.

The company enters into a normal loan but independently organises a forward
rate agreement with a bank:
 interest is paid on the loan in the normal way
 if the interest is greater than the agreed forward rate, the bank pays the
difference to the company
 if the interest is less than the agreed forward rate, the company pays the
difference to the bank.

Test your understanding 26

Nero Co’s cash flow forecast shows that it will have to borrow $2m from
Goodfellow’s Bank in four months’ time for a period of three months. The
company fears that by the time the loan is taken out, interest rates will have

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risen. The current interest rate is 5% and this is offered by Helpy Bank on the
required FRA.
Required
I. What kind of FRA is needed?
II. What are the cash flows if the interest rate has risen to 6.5% when the
loan is taken out?
III. What are the cash flows if the interest rate has fallen to 4% when the
loan is taken out?

Test your understanding 27

Lynn plc is a UK listed company. It is 30 June. Lynn will need a £10 million 6-
month fixed rate loan from 1 October. Lynn wants to hedge its exposure to the
risk of a rise in the 6-month interest rate between the end of June and 1
October, using an FRA. The relevant FRA rate is 6% on 30 June and the
reference rate for the FRA is the 6-month LIBOR rate.
(a) State what FRA is required.
(b) What is the result of the FRA and the effective loan rate if the spot 6-month
LIBOR rate (the benchmark or reference rate for the FRA) is:
(i) 5%
(ii) 9%

INTEREST RATE DERIVATIVES

The interest rate derivatives that will be discussed are:
I. Interest rate futures
II. Interest rate options
III. Interest rate caps, floors and collars
IV. Interest rate swaps

INTEREST RATE FUTURES

Futures contracts are of fixed sizes and for given durations. They give their
owners the right to earn interest at a given rate, or the obligation to pay
interest at a given rate.

Selling a future creates the obligation to borrow money and the obligation

to pay interest
Buying a future creates the obligation to deposit money and the right
to receive interest.

Interest rate futures can be bought and sold on exchanges such as

Intercontinental Exchange (ICE) Futures Europe.

The price of futures contracts depends on the prevailing rate of interest and it

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is crucial to understand that as interest rates rise, the market price of futures
contracts falls.

 A rise in interest rates reduces futures prices.

 A fall in interest rates increases futures prices.

In practice, futures price movements do not move perfectly with interest rates
so there are some imperfections in the mechanism. This is known as basis
risk.

The approach used with futures to hedge interest rates depends on two
parallel transactions:
 Borrow/deposit at the market rates
 Buy and sell futures in such a way that any gain that the profit or loss on
the futures deals compensates for the loss or gain on the interest
payments.

Borrowing or depositing can therefore be protected as follows:

Depositing and earning interest

The depositor fears that interest rates will fall as this will reduce income.
If interest rates fall, futures prices will rise, so buy futures contracts now (at
the relatively low price) and sell later (at the higher price). The gain on futures
can be used to offset the lower interest earned.
Of course, if interest rates rise the deposit will earn more, but a loss will be
made on the futures contracts (bought at a relatively high price then sold at a
lower price).

Borrowing and paying interest

The borrower fears that interest rates will rise as this will increase expense.
If interest rates rise, futures prices will fall, so sell futures contracts now (at
the relatively high price) and buy later (at the lower price). The gain on futures
can be used to offset the lower interest earned.
Of course, if interest rates fall the loan will cost less, but a loss will be made
on the futures contracts (sold at a relatively low price then bought at a higher
price).
Once again, the aim is stability of the combined cash flows.

Summary
The summary rule for interest rate futures is:
 Depositing: buy futures then sell
 Borrowing: sell futures then buy

INTEREST RATE OPTIONS

Interest rate options allow businesses to protect themselves against adverse
interest rate movements while allowing them to benefit from favourable
movements. They are also known as interest rate guarantees. Options are like

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insurance policies:
I. You pay a premium to take out the protection. This is non-returnable
whether or not you make use of the protection.
II. If interest rates move in an unfavorable direction you can call on the
insurance.
III. If interest rates move favourable you ignore the insurance.

Options are taken on interest rate futures contracts and they give the holder
the right, but not the obligation, either to buy the futures or sell the futures at
an agreed price at an agreed date.

Using options when borrowing

As explained above, if using simple futures contracts the business would sell
futures now then buy later.
When using options, the borrower takes out an option to sell futures contracts
at today’s price (or another agreed price). Let’s say that price is 95. An option
to sell is known as a put option (think about putting something up for sale).
If interest rates rise the futures contract price will fall, let’s say to 93. Therefore
the borrower will buy at 93 and will then choose to exercise the option by
exercising their right to sell at 95. The gain on the options is used to offset the
extra interest that has to be paid.
If interest rates fall the futures contract price will rise, let’s say to 97. Clearly,
the borrower would not buy at 97 then exercise the option to sell at 95, so the
option is allowed to lapse and the business will simply benefit from the lower
interest rate.

Using options when depositing

As explained above, if using simple futures contracts the business would buy
futures now and then sell later.
When using options, the investor takes out an option to buy futures contracts
at today’s price (or another agreed price). Let’s say that price is 95. An option
to buy is known as a call option.

If interest rates fall the futures contract price will rise, let’s say to 97. The
investor would therefore sell at 97 then exercise the option to buy at 95. The
gain on the options is used to offset the lower interest that has been earned.
If interest rates rise the futures contract price will fall, let’s say to 93. Clearly,
the investor would not sell futures at 93 and exercise the option by insisting on
their right to sell at 95. The option is allowed to lapse and the investor enjoys
extra income form the higher interest rate.

Options therefore give borrowers and lenders a way of guaranteeing minimum

income or maximum costs whilst leaving the door open to the possibility of
higher income or lower costs. These ‘heads I win, tails you lose’ benefits have
to be paid for and a non-returnable premium has to be paid up front to
acquire the options.
 

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