Synopses & Reviews
The effects of interest rate changes on a business can be drastic. Should interest rates change over time, a company can find itself with a burden of debt it is unable to service, or an income that is far less than expected. This can have a very damaging effect on a company's financial performance if it is not anticipated.
In this book, John Stephens demonstrates how to manage this risk with the use of financial derivatives. An in-depth knowledge of mathematics, interest rates, or derivatives is not required in order to understand or practice the techniques in this book. The author explains in full the nature and uses of all techniques to manage interest rate risk.
This book examines, in a balanced and objective fashion, the extent to which financial derivatives can be used to reduce the exposure of a business to risk. Beginning with a general overview of the definitions, processes and procedures, the book then separately explains in detail each of the individual approaches. Topics dealt with include:
- Interest spot and FRA markets
- Interest rate futures contracts
- Interest rate swaps
- Interest rate options
Synopsis
As with previous titles in the IIA (Institute of Internal Auditors) series this is a clear and practical guide to a subject of key importance to financial managers. Whether borrowing, investing, saving or trading, a company will always have to take into account the cost of capital and therefore interest rate risk. The highly accessible style explains everything from the basic principles through to the techniques allowing those without prior knowledge to understand the nature and use of a variety of financial tools, including derivative instruments. This is the third part of the trilogy on market risk, the previous two being Managing Currency Risk and Managing Commodity Risk.
Synopsis
Economic conditions can change dramatically over time, requiring significant changes in interest rates. Loans that appeared desirable methods of expansion when taken out can, with a change in interest rates, become massive outgoings that leave the unprepared business exposed to potentially crippling debt.
Whether borrowing, investing, saving or trading, a company will always have to take into account the cost of capital and therefore interest rate risk. The efficient management of this risk is essential for the survival of a company and any business that is exposed to such a risk should ensure that it is fully prepared to manage it.
Aimed at senior managers within businesses, this book is a practical primer on how to reduce risk from changes in interest rates.
About the Author
JOHN J. STEPHENS has many years' international business and banking experience. Trained as a lawyer, he subsequently specialised in business related issues and for 10 years was CEO of a management consultancy firm with many large international clients. From 1992 onwards, he worked in the financial services sector for SANLAM and later ABSA Bank, before specialising in futures and options. He now runs a training company specialising in the futures and derivatives markets and is also a non-practicing advocate of the Supreme Court of South Africa.
Table of Contents
PREFACE
Modern Risk Management and the Non-Financial Sector
The Scope and Purpose of the Book
The Methodology
Risk Management and Risk Quantification
The Role of Pricing Derivatives
Structure of the Book
CHAPTER 1 INTEREST RATE RISK, INTEREST RATE DERIVATIVES AND THE MANAGEMENT FUNCTION
Introduction
Fundamentals of Interest Rate Risk
Financial Derivatives
Interest Rate Derivatives
The Interest rate Risk Management Function
CHAPTER 2 INTEREST RATE RISK MANAGEMENT IN THE NON-FINANCIAL SECTOR
Introduction
The Critique of Corporate Risk Management
In Defence of Corporate Risk Management
Conclusion on Corporate Risk Management
Maintaining a Sound System of Control
Diversification
Hedging With Financial Derivatives
CHAPTER 3 INTEREST SPOT AND FRA MARKETS
The Spot Interest Rate Market
Forward Rate Agreements
Case Study 1 Using a FRA to Lock in Future Borrowing Rates
CHAPTER 4 INTEREST RATE FUTURES CONTRACTS
Introduction to Interest Rate Futures
An Exchange Traded Forward Rate Agreement
A Standardised Contract - the Minimum Conditions
Major Interest Rate Futures Contracts
Futures Market Terminology
The Role of Basis in Interest rate futures
The Futures Hedge Ratio
Case Study 2 Hedging a Borrowing Rate with Eurodollar Futures
Case Study 3 Hedging an Investment Rate with Eurodollar Futures
Discussion of the Case Studies
CHAPTER 5 INTEREST RATE SWAPS
Introduction to Interest Rate Swaps
Principles of Interest Rate Swaps
Uses of interest rate swaps
Structuring Interest Rate Swaps
The Swap Rate
Practical Interest Rate Swaps
Case Study 4 Hedging a term loan with an interest rate swap.
Asset Swaps
Interest Rate Basis Swaps
Case Study 5 Managing Interest Rate Risk with a Basis Swap
CHAPTER 6 INTEREST RATE OPTIONS
Introduction
The Fundamental Principles of Options
Option Pricing
The Intrinsic Value of an Option
The Time value of an Option
The Greeks
Exercising Options
The Risk of the Parties to an Option
OTC Interest Rate Guarantees
Case Study 6 Locking in a borrowing rate with an IRG
OTC Option Variants
Options on Interest rate futures
Option Standardisation
Option Classification
Selling Options on Futures
Case Study 7 Hedging an interest bearing investment using options on futures
CHAPTER 7 STRATEGIES WITH INTEREST RATE SWAPS, SWAPS BASED DERIVATIVES AND SWAPS MIMICS
Introduction
Strategies with Standard Interest Rate Swaps
Case Study 8 A Debt Market Arbitrage
Case Study 9 Arranging an Off-Market Swap
Swaps Strategies with special terms
Case Study 10 Structuring a Callable Fixed Rate Swap
Case Study 11 Hedging a borrowing rate with an adjustable fixed rate swap
Swaps as the Underlying Asset of Other Derivatives
Futures on Swaps
Options on Swaps
Case Study 12 Hedging the swap rate on future borrowings using a swaption
Strategies Mimicking Swaps
Case Study 13 Hedging a borrowing rate with a futures strip
CHAPTER 8 STRATEGIES WITH INTEREST RATE OPTIONS AND EXOTIC INTEREST RATE OPTIONS
Introduction
Cost Reduction Strategies
Case Study 14 Locking in a borrowing rate with OTM options on futures
Case Study 15 Hedging borrowing rates with an interest rate collar
Zero Cost Strategies
Case Study 16 Hedging future borrowing rates using a borrower's interest rate lock
Case Study 17 Hedging a borrowing rate with a Participating Interest Rate Cap
Exotic Options