Chapter 20 Interest Rate Risk

Interest
Rate
Risk

Interest Rate Cause of Interest Rate

Risk Interest Rate Risk
Fluctuations Management

Gap/Interest rate Structure of Yield 1. Matching &

exposure interest rates curve smoothing

Basis 2. Forward rate

risk 1. Risk 1. Liquidity agreements
preference
theory
3. Futures
2. Need to make 2. Expectations contracts
profit on re-lending theory
for banks
4. Interest rate
3. Size of loan 3. Market options
segmentation
theory
5. Interest rate
4. Government caps, collars &
policy floors

6. Interest rate
5. Types of swaps
financial assets

6. Duration of
lending
Multiple Choice Questions

1. Which is the best definition of basis risk?

A Interest rates on deposits and on loans are revised at different times.

B Interest rates on deposits and loans move by different amounts.
C Interest rates move.
D The bank base rate might move with a knock on effect to other interest rates.

2. If a business benefits from gap exposure what does this mean?

A The timing of interest rate movements on deposits and loans means it has made a
profit
B The timing of interest rate movements on deposits and loans means it has made a
loss
C The interest rates reduce between deciding a loan is needed and signing for that
loan.
D The inefficiencies between two markets means arbitrage gains are possible.

3. Which of the following is NOT an explanation of a downward slope in the yield curve?

A Liquidity preference
B Expectations theory
C Government policy
D Market segmentation

4. An inverse yield curve is a possible indication of

A An expected rise in interest rates

B An expected fall in interest rates
C Higher expected inflation
D Lower expected inflation

5. A yield curve shows

A the relationship between liquidity and bond interest rates

B the relationship between time to maturity and bond interest rates
C the relationship between risk and bond interest rates
D the relationship between bond interest rates and bond prices

6. Which of the following statements is correct?

A Governments can keep interest rates low by buying short-dated government bills in
the money market
B The normal yield curve slopes upward to reflect increasing compensation to
investors for being unable to use their cash now
C The yield on long-term loan notes is lower than the yield on short-term loan notes
because long-term debt is less risky for a company than short-term debt
D Expectations theory states that future interest rates reflect expectations of future
inflation rate movements
7. Consider the following statements concerning forward rate agreements (FRAs):

1. FRAs cannot be tailored to the specific requirements of a customer.

2. FRAs are binding agreements that must be settled at the settlement date.
3. FRAs do not require any payments or receipts until the settlement date.
4. FRAs can be resold in the secondary market.

Which of the above statements are correct?

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

8. A company plans to take out a $50 million loan in six months’ time and wishes to fix the
interest rate for a 12-month period. The company wants to use a forward rate agreement
to hedge the interest rate risk and the following rates have been quoted by a bank:

Bid % Offer %
6 v 12 5.65 5.60
6 v 18 5.70 5.64

LIBOR is 5·5% at the fixing date and the company can borrow at 45 basis points above
this figure.

What rate of interest will the company pay to, or receive from, the bank as a result of the
forward rate agreement?

A 0·15% paid to bank

B 0·20% paid to bank
C 0·25% received from bank
D 0·31% received from bank

9. Indus plc wishes to fix the interest rate for a six-month period on a £20 million loan that
it plans to take out in three months’ time. The company decides to use a forward rate
agreement (FRA) to hedge the interest rate risk and a bank quotes the following rates:

Bid Offer
3v6 6.60 6.56
3v9 6.65 6.61

The company can borrow at 60 basis points above LIBOR and, at the fixing date, the
relevant LIBOR is 6·4%.

What is the amount of interest (in percentage terms) that the company will pay to, or
receive from, the bank as a result of the forward rate agreement?

A0·20% paid to bank

 B 0·25% paid to bank
C 0·35% received from bank
D0·39% received from bank

10. LIBOR rates are quoted as follows for FRAs.

2v5 3.37% – 3.32%

3v5 3.45% – 3.39%

A company can borrow at 65 basis points over LIBOR. In order to stabilise its finance
costs, it wants to fix the interest rate for a three-month borrowing starting in two months’
time.

What is the effective rate of interest that the company will fix its loan?

A 4·10%
B 4·04%
C 4·02%
D 3·97%

11. It is 30 June. Greg plc will need a $10 million 6 month fixed rate loan from 1 October.
Greg wants to hedge using a forward rate agreement (FRA). The relevant FRA rate is 6%
on 30 June.

What is the compensation payable/receivable if in 6 months' time the market rate is 9%?

A $150,000 receivable
B $150,000 payable
C $450,000 receivable
D $450,000 payable

12. Which of the following statements, concerning interest rate futures, is incorrect?

A Interest rate futures can be used to hedge against interest rate changes between the
current date and the date at which the interest rate on the lending or borrowing is
set
B Borrowers buy futures to hedge against interest rate rises
C Interest rate futures have standardised terms, amounts and periods
D The futures price is likely to vary with changes in interest rates

13. Consider the following statements concerning financial options.

1 An interest rate cap is a series of lenders’ options on a notional loan.

2 An American-style option may be exercised before the expiry date of the option.

Which of the following combinations (true/false) concerning the above statements is

correct?
 Statement 1 Statement 2
A True True
B True False
C False True
D False False

14. Consider the following statements concerning financial derivatives.

1. Interest rate swaps are a form of over-the-counter derivative.
2. A European-style option will give the right to buy or sell at any time up to and
including the expiry date.

Which ONE of the following combinations (true/false) is correct?

Statement 1 Statement 2
A True True
B True False
C False True
D False False

15. In relation to hedging interest rate risk, which of the following statements is correct?

A The flexible nature of interest rate futures means that they can always be matched
with a specific interest rate exposure
B Interest rate options carry an obligation to the holder to complete the contract at
maturity
C Forward rate agreements are the interest rate equivalent of forward exchange
contracts
D Matching is where a balance is maintained between fixed rate and floating rate debt
(ACCA F9 Financial Management Pilot Paper 2014)

16. Which of the following is true of exchange traded interest rate options?

1 They maintain access to upside risk whilst limiting the downside to the premium.
2 They can be sold if not needed.
3 They are expensive.
4 They are tailored to an investor’s needs.

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

17. An interest rate swap

A allows the company a period of time during which it has the option to buy a forward
rate agreement at a set price
B locks the company into an effective interest rate
C is an agreement whereby the parties to the agreement exchange interest rate
commitments
 D involves the exchange of principle

18. Which of the following statements are correct?

(1) Interest rate options allow the buyer to take advantage of favourable interest rate
movements
(2) A forward rate agreement does not allow a borrower to benefit from a decrease in
interest rates
(3) Borrowers hedging against an interest rate increase will buy interest rate futures
now and sell them at a future date

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