Module - 5 : Management of interest rate exposure – nature and measurement – forward rate agreements ( FRA’s ) interest rate options, caps, floors and collars, cap and floors – options on interest rate futures, some recent innovations – financial swaps.

2. Module - 5 :
Management of interest rate exposure – nature and
measurement – forward rate agreements ( FRA’s )
interest rate options, caps, floors and collars, cap and
floors – options on interest rate futures, some recent
innovations – financial swaps.

3. INTEREST RATE EXPOSURES
The amount of financial loss a company or individual could be
incurred as a result of adverse changes in interest rates. A risk
common to both businesses and individuals involves
refinancing debt in an increasing interest rate environment.
Interest rate risk exists in an interest-bearing asset, such as a
loan or a bond, due to the possibility of a change in the asset's
value resulting from the variability of interest rates. Interest
rate risk management has become very important, and assorted
instruments have been developed to deal with interest rate
risk. This article introduces you to ways that both businesses
and consumers manage interest rate risk using various interest
rate derivative instruments.

4. NATURE & MEASUREMENT – INTEREST RATE
EXPOSURE
1. Net Interest Income – Interest income on assets minus interest
expense on liabilities.
2. Net Equity Exposures – Sensitivity of the firm’s net worth to
interest rates.
3. Credit Exposure which is really a measure of default risk.
Most firms would wish to limit their exposure to any one
individual or firm.
4. Basis risk arises when interest rate exposure on one
instrument, e.g. commercial paper is offset with another
instrument.
5. Liquidity risk pertains to timing mismatches between cash
inflows and outflows. e.g. when a longer duration asset is
funded by a shorter duration liability which will have to be
refunded at maturity possibly at a higher cost.

5. FORWARD RATE AGREEMENTS (FRAs)
A Forward Rate Agreement, or FRA, is an agreement between two
parties who want to protect themselves against future movements in
interest rates. By entering into an FRA, the parties lock in an interest rate
for a stated period of time starting on a future settlement date, based on a
specified notional principal amount.
The buyer of the FRA enters into the contract to protect itself from a
future increase in interest rates. This occurs when a company believes
that interest rates may rise and wants to fix its borrowing cost today. The
seller of the FRA wants to protect itself from a future decline in interest
rates. This strategy is used by investors who want to hedge the return
obtained on a future deposit.
FRAs are settled using cash on the settlement date. This is the start date
of the notional loan or deposit. The exposure to each counterparty is
determined by the interest rate differential between the market rate on
settlement date and the rate specified in the FRA contract. There are no
principal flows.

6. The FRA is a very flexible instrument and can be tailored to
meet the needs of both the buyer and seller to protect
themselves against the volatility of interest rates which affect
their future borrowings or investments. The principle
advantages of FRAs are:
1. contracts can be structured to meet the specific needs of the
user;
2. counterparty exposure is limited to the interest rate
differential between the market rate and the contract rate;
3. administration costs are minimized as there is only one
cash flow on the settlement date as opposed to daily futures
settlement;
4. they are off-balance sheet items; and
5. they can easily be reversed or closed out using an offsetting
FRA at a new price.

7. 1. Usually cash-settled
2. Net amount is settled (difference between the current
LIBOR and the agreed FRA rate)
3. Payment made only at maturity
4. How a Long Position will Benefit?
5. How a Short Position will benefit?
6. Deposit amount is known as Notional Amount
7. Determined on Short-term Interest rates (Reference Rates)
CHARACTERISTICS OF FRAs
Two parties can enter into an agreement to borrow $1 million
after 60 days for a period of 90 days, at say 5%.
Borrower tries to protect his cost of borrowing due to the rise in
interest rates. Lender or seller is expecting interest rates to fall
and is thus looking to lock in the rate at which he will lend.

8. How is the Forward Rate Determined?
• The interest rate for the shorter period is the market yield
with the term equal to the number of days from the
agreement date until the contract begins.
The longer period is determined using the market yield with
the term equal to the number of days from the agreement
date until the contract ends.

9. where
rc = FRA contract rate
rm = market rate
npa = notional principal amount
dt = maturity date of underlying FRA contract
de = settlement date of FRA contract
year_basis = number of days in year for particular accrual method
S = settlement amount
FORMULA - FRAS

10. The buyer of a FRA agrees to pay a fixed-rate coupon payment
(at the exercise rate) and receive a floating-rate payment against
a notional principal amount at a specified future date.
The buyer of a FRA will receive (pay) cash when the actual
interest rate at settlement is greater than the exercise rate
(specified fixed-rate).
The seller of a FRA agrees to make a floating-rate payment and
receive a fixed-rate payment against a notional principal amount
at a specified future date.
The seller of a FRA will receive (pay) cash when the actual
interest rate at settlement is less than the exercise rate.
A forward rate agreement (FRA)
…a forward contract based on interest rates

11. INTEREST RATE OPTIONS
An Interest rate option is a specific financial derivative
contract whose value is based on interest rates. Its value is
tied to an underlying interest rate, such as the yield on 10
year treasury notes. Similar to equity options, there are two
types of contracts: calls and puts.
FINANCIAL SWAPS
A swap is a derivative in which two counterparties exchange
cash flows of one party's financial instrument for those of the
other party's financial instrument. The benefits in question
depend on the type of financial instruments involved. ... The
cash flows are calculated over a notional principal amount

12. An interest rate cap is an agreement between two parties
providing the purchaser an interest rate ceiling or 'cap' on
interest payments on floating rate debts. The rate cap itself
provides a periodic payment based upon the positive amount
by which the reference index rate (e.g. 3m LIBOR) exceeds
the strike rate.
An interest rate floor on the other hand, guarantees a lower
bound for the rate of interest received on an investment, when
used in conjunction with a long position in a Floating Rate
Note (FRN). The rate floor itself provides a periodic payment
based upon the positive amount by which the strike rate
exceeds the reference rates.
A Combination of Caps and Floors are called Collars.

13. Caps
A Cap is a series of sequentially maturing European style call
options that protect the purchaser from a rise in a floating rate
index, usually LIBOR, above a predetermined level. The
purchaser has the right to receive a periodical cash flow equal
to the difference between the market rate and the strike,
effectively placing a maximum limit on interest payments on
floating rate debt.
N
o
C
ap
Cap Rate
FloatingInterestRate
Reference Rate
Cap Payoff
Gain
Cap
)0,max( Kkk RRL 

14. Floors
Interest rate floor is similar to cap except that it is
structured to hedge against decreasing interest rates (or
down-side risk). An interest rate floor closely resembles a
portfolio of put option contracts.
Floor Rate
FloatingInterestRate
Reference Rate
Floor Payoff
N
o
Floor
Floor
Gain
  max , ,0i iN K l t t  

15. • It is the combination of a Cap and a Floor.
• It consist of buying a cap and selling a floor or vice versa.
• Zero Cost Collar exists when the premium of the floor
exactly matches that of the cap.
Collar
     360,0max,0max  tfc drrrrN
N is the notional principal amount of the agreement
rc is the cap rate
rf is the floor rate
dt is the term of the index in days.

16. Profit
rf
Interest
Rate+ =
rc
rf
rc
a. Buy Cap b. Sell Floor c. Buy Collar
Collar
- Pay-off graphs of zero-cost Collar

17. Example: A customer is borrowing $10 million at 1 month.
LIBOR plus 200 bps, for a current rate of 7.75% (LIBOR is currently at
5.75%), from ABC Bank. The customer wishes to cap LIBOR so that it
does not exceed 6%.
In order to reduce the cost of the cap, the borrower sells a floor to ABC
Bank with a strike of 4%.
ABC Bank and the customer have created a “band” within which the
customer will pay LIBOR plus the borrowing spread of 200 bps.
If LIBOR drops below the floor, the customer compensates ABC Bank.
If LIBOR rises above the cap, ABC Bank compensates the borrower.
The customer has foregone the benefit of reduced interest rates should
LIBOR ever fall below 4%. In this example, the customer never pays
more than 8% or less than 6%.

18. Provides protection against interest rate increase and gain
from interest rate decrease.
It can be used as a form of short-term interest rate protection
in times of uncertainty.
It can be structured so that there is no up-front premium
payable (Zero-cost Collar).
It can be cancelled, however there may be a cost in doing so.
Collar - Advantages
It provides you with some ability to participate in interest rate
decreases with the Floor rate as a boundary.
To provide a zero cost structure or a reasonable reduction in
premium payable under the Cap, the Floor Rate may need to
be set at a high level. This negates the potential to take
advantage of favorable market rate movements
Collar - Disadvantages

19. RECENT INNOVATIONS
Exotic caps and floors
There is more contract trade on the international Over –
The – Counter market with cash flows. They are similar
to the previous ones but more complex
•Knock-out cap
•Bounded cap
•Flexible cap
•Flexible floor