ACCA F9 Financial Management - 2010 - Study text

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Chapter 19: Foreign exchange risk

The nature of currency swaps

The main features of a currency swap are as follows.

 The two parties to a currency swap, a company and a bank, agree to swap

‘interest payments’ on a notional amount of principal. One party pays interest on

a notional amount of principal in one currency, and the other party pays

‘interest’ on a notional amount of principal in a second currency.

 The two notional amounts of principal should be equivalent, so there is an

agreed exchange rate between the currencies implicit in the transaction.

 The ‘interest’ payments are made at regular intervals, at a rate of interest

specified in the swap agreement.

 At the end of the swap, the two parties make an exchange of principal, paying

each other the notional amount of principal in the swap.

Example

A US company arranges a five-year currency swap with a bank. Under the terms of

the agreement, the US company will pay the swaps bank interest on 60 million

Argentinian pesos, and the bank will pay interest in return on US$20 million.

Under the terms of the agreement, ‘interest’ payments will be exchanged every six

months, with the US company paying interest at 8% per annum on 60 million pesos

and the bank paying interest at 4.5% on US$20 million.

At the end of the swap, the US company will pay the bank 60 million pesos and will

receive in return US$20 million.

This type of arrangement might enable the US company to hedge exposures to

currency risk if it has invested in a five-year project in Argentina, and expects to

receive cash in pesos from the investment. It can use its pesos from the project to

make the payments under the terms of the currency swap.

If it sells off its investment after five years and receives payment in pesos, the

money it receives can be used to pay the 60 million pesos to the swaps bank at the

end of the swap.

By netting or matching receipts and payments in pesos, the currency risk exposure

has been hedged.

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Example

Another use of currency swaps for hedging is illustrated by the following example

A UK company has taken an opportunity to borrow US$200 million in the bond

markets, by issuing a seven-year bond. However, it wants to have its interest

liabilities in sterling, not dollars. It might therefore arrange a seven-year currency

swap in which the agreed exchange rate is £1 = US$2.00.

 For the seven years of the swap, the UK company will receive a fixed rate

interest in US dollars from the swap counterparty. The interest received on each

interest payment date will be interest for the period at the agreed swap rate for

US dollars, on $200 million.

 The UK company will pay interest in the swap on £100 million, also at a fixed

rate agreed in the swap.

 The interest received in US dollars can be used to meet the dollar interest

liabilities on the bonds. This leaves the company with net interest obligations in

sterling.

 At the end of the swap, there is an exchange of principal. The UK company will

receive US$200 million from the swap counterparty and in exchange must pay

£100 million. It will use the US$200 million to redeem the dollar bonds.

The effects of the currency swap may be summarised as follows:

 Interest

Principalpayments

(endoftheswap)

Bonds Paydollars Paydollars($200million)

Currencyswap Receivedollars Receivedollars($200million)

 Paysterling 



–––

–

––––

–

––

–

–––––––

Neteffect Paysterling Nil



–––

–

––––

–

––

–

–––––––

The effect of the currency swap has therefore been to borrow in one currency, but

swap the interest and loan principal repayment liabilities into a different currency.

Currency swaps are therefore used to hedge long-term currency risk exposures.

7.10 Conclusion: using currency derivatives

It is important to remember that although some companies might use derivatives to

hedge currency risk exposures, it is much more common for companies to use

hedging techniques and methods such as netting, leading or lagging, forward

exchange contracts and money market hedges.

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Financial management

CHAPTER

Interest rate risk

Contents

1 Thenatureofinterestraterisk

2 Yieldcurvesandinterestfluctuations

3 Hedginginterestraterisk:FRAs

4 Interestrateswaps

5 Usinginterestrateswaps

6 Short‐terminterestratefutures(STIRs)

7 Interestrateoptions

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The nature of interest rate risk

 The effect of a change in interest rates

 Interest rate volatility and interest rate risk

 Short-term and long-term interest rates

 Money market interest rates: LIBOR

 Types of interest rate risk

 Basis risk

 Gap exposure

1 The nature of interest rate risk

1.1 The effect of a change in interest rates

Interest rates can move up or down. Economists are often able to predict the

direction of future movements over the fairly short term, but might not be able to

predict exactly when interest rates might change, nor by exactly how much.

Interest rate risk is the risk that arises from the potential consequences of

unexpected movements, up or down, in an interest rate. Financial institutions such

as banks and investment institutions such as pension funds have the largest

exposures to interest rate risk, because of their extensive borrowing, lending and/or

investments. However, interest rate risk affects any entity or individual who

borrows money or who invests in interest-yielding investments.

A movement in interest rates can affect companies in either a positive or a negative

way.

 If a company has borrowed at a variable rate of interest, it will have to pay

higher interest costs if the interest rate goes up. On the other hand it will pay

lower interest costs the interest rate goes down.

 If a company has borrowed at a fixed rate of interest, for example by issuing

bonds, it will continue to pay the same rate of interest even if market interest

rates go down. However, competitors who have borrowed at a variable rate of

interest, or competitors who decide to issue fixed rate bonds after the rate has

fallen, will gain a competitive advantage.

 An investor in fixed rate bonds who expects to sell the bonds before their

maturity will also be affected by a change in interest rates. A rise in interest

yields will result in a fall in the market price of existing fixed rate bonds. A fall

in the market interest rate results in higher market prices for (fixed rate) bonds.

Companies with very large borrowings are exposed to significant interest rate risk.

For example, if a company has borrowed $500 million from a syndicate of banks at a

variable rate of interest, an increase in the annual interest rate of just 0.25% will

result in higher interest costs of $1,250,000 each year.

Chapter 20: Interest rate risk

1.2 Interest rate volatility and interest rate risk

Interest rates are volatile when they change frequently and the direction of the

change, up or down, is difficult to predict.

Interest rate risk is particularly high when:

 interest rate changes are frequent (and sometimes large), and

 it is uncertain whether the next movement in rates will be up or down.

In other words, interest rate risk increases with interest rate volatility. Volatility is

likely to be higher when expected inflation rates are high than when expected

inflation rates are low.

1.3 Short-term and long-term interest rates

A distinction is made between:

 short-term interest rates, which are money market interest rates

 long-term interest rates, which are bond yields.

Volatility in short-term rates affects short-term lending and borrowing, and also all

lending at a variable rate of interest, such as most bank loans. Volatility in longer-

term rates affects bond investors.

Note that yields on a corporate bond are affected by:

 interest rates for risk-free bonds (domestic government bonds)

 changes in the perceived credit risk of the bond issuer.

For example, suppose that a company’s bonds which have been rated AA by a

credit rating organisation are now downgraded to a rating of A+. The yield on the

bond will increase to reflect the lower credit rating, and the market price of the

bonds will fall. However, the increase in the bond yield is due to a credit risk factor

rather than to interest rate risk.

1.4 Money market interest rates: LIBOR

Short-term interest rates for borrowers are set at a margin above either:

 the base rate or official rate of the lending bank, or

 an ‘official’ money market rate. (Note: The money markets are markets for

wholesale borrowing and lending short-term, for periods ranging from

overnight up to about 12 months. ‘Wholesale’ means borrowing and lending in

large amounts.)

Each major financial centre has a money market and a ‘benchmark’ rate that the

participants in the market use. In London, the benchmark rate of interest is the

London Interbank Offered Rate or LIBOR. This is the rate of interest at which a bank

will lend to a top-rated bank in the interbank market.

 There are LIBOR rates for each maturity of lending, such as seven-day LIBOR,

one-month LIBOR, three-month LIBOR and so on.

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 Each individual UK bank has its own LIBOR rates, but an average ‘official’

LIBOR rate is calculated daily by the British Bankers Association.

 London is a major international money market centre, and there are LIBOR rates

in the major currencies as well as in sterling. For example, there is a US dollar

LIBOR and a Swiss franc LIBOR. There is also a euro LIBOR, but the commonly-

used benchmark rate for the euro is a rate called the euribor rate.

 In Paris, there are PIBOR rates; in Frankfurt there are FIBOR rates; and so on.

A company borrowing British pounds from a bank at a floating rate of interest

might pay interest at a margin above LIBOR. For example, if interest is payable

every six months, a borrower might pay interest at 1.50% above the six-month

sterling LIBOR rate.

(Basis points: 1% = 100 basis points, and in the money market, interest rates may be

stated as a number of basis points above LIBOR. So LIBOR plus 1.50% might be

stated as 150 basis points above LIBOR.)

When a company borrows at a variable rate of interest, it pays interest at the end of

each interest period, which might be each month, or every three months, or every

six months, and so on. The rate of interest payable for the period is decided by

reference to the benchmark rate, such as three-month LIBOR, at the beginning of

the interest period. As LIBOR rises or falls, the interest payable in each interest

period also goes up or down.

Calculating the interest

There are rules in the money markets about how interest should be calculated. The

rules differ between currencies. For example:

 Interest on a sterling money market loan is calculated as:

Loan principal × Annual interest rate × (Number of days in the loan period/365)

 Interest on a US dollar money market loan is calculated as:

Loan principal × Annual interest rate × (Number of days in the loan period/360)

For your examination, you might be expected to make the assumption that interest

is calculated as:

Loan principal × Annual interest rate × (Number of months in the loan period/12).

1.5 Types of interest rate risk

The main interest rate risk for non-bank companies is the risk from an unexpected

rise or fall in interest rates.

 If interest rates rise, the cost of borrowing will rise for a company with a variable

rate loan. For example, a company with a five-year variable rate loan on which

the interest rate is three-month LIBOR plus 1.5% will have to pay more interest if

the LIBOR rate goes up.

Chapter 20: Interest rate risk

 If interest rates fall, for a company with fixed rate debt the cost of borrowing will

become higher relative to rival companies that have variable rate borrowing. For

example, if a company has issued 6% fixed rate bonds, the relative cost of

borrowing will become higher if short-term rates such as the LIBOR rate fall.

 If interest rates rise, investors holding fixed rate bonds will suffer a loss in value

on their bonds. This is because whenever interest rates rise, the market value of

fixed rate bonds falls.

In addition to risk from unexpected movements up or down in the general rate of

long-term or short-term interest, there are other types of interest rate risk. These

include:

 basis risk

 gap exposure.

1.6 Basis risk

Basis risk is where an organisation has assets and liabilities with floating interest

rates but the interest rates are set on different bases. Examples of different bases for

calculating interest are:

 loans with interest charged at the bank’s base rate plus

 loans with interest charged at three-month LIBOR plus, or at six-month LIBOR

plus.

When one interest rate basis changes, others might not. For example, if there is a fall

in LIBOR, a bank’s official base rate might not be altered. Similarly if three-month

LIBOR goes up by, say, 0.25%, six-month LIBOR might go up by a smaller or a

larger amount.

Example

An investor has borrowed money at his bank’s base rate plus 1% and has invested it

in floating rate bonds on which the interest is LIBOR plus 1.25%.

Basis risk exists because the basis on which interest is payable (bank’s base rate) and

the basis on which interest is receivable (LIBOR) are different. There is a risk that

one of these interest rates might change but the other remains unchanged. For

example, the lending bank might raise its base rate by 0.25% but LIBOR might

remain unchanged.

1.7 Gap exposure

Gap exposure is where a company has assets and liabilities maturing over different

periods. A risk arises because interest rates might change for the period or time

‘gap’ between the date when the assets mature and the date when the liabilities

mature.

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Example

An investor has an investment that cost $2 million and is earning interest at 5.5%

per year. This investment will mature in three months time, when $2 million will be

repayable to the investor.

The investment is financed by a loan on which the interest cost is 5.25% per year.

This loan is repayable in five months.

There is a gap between the time the investment matures (after three months) and the

maturity of the loan (after five months). During month 4 and month 5, the investor

will continue to pay interest at 5.25%. He will be able to reinvest his $2 million for

two months to earn more interest, but there is a risk that interest rates might fall and

the interest he will learn in those months could be less than the cost of his

borrowing.

Example

A bank borrows funds from another bank for three months at an interest rate of

LIBOR plus 0.25, and it uses the funds to re-lend for six months to a customer at

LIBOR plus 0.75%.

The bank will have to repay the loan after three months, and so will have to find

new funding for months 4 – 6. There is a gap between the maturity date of the

liability and the maturity date of the asset. There is a risk that interest rates might go

up, so that the cost of replacement funding at the end of month 3 could be higher

than the interest the bank is receiving on its loan to the customer.

Chapter 20: Interest rate risk

Yield curves and interest rate fluctuations

 Structure of interest rates and yield curves

 Causes of interest rate movements

 Expectations theory

 Liquidity preference theory

 Market segmentation

2 Yield curves and interest rate fluctuations

2.1 Yield curves (the term structure of interest rates)

The cost of interest on bonds is the current investment yield required by investors

from their investment in the bonds. The cost of fixed-rate debt, commonly referred

to as the ‘interest yield’, differs according to the remaining term to maturity of the

debt.

For example, suppose that there are two different bonds, one that will mature in

three years and the other that will mature in seven years. Even if there is no

difference in investment risk between the two bonds (so risk does not affect the

comparative yield), the interest cost of the three-year bonds and the interest cost of

the seven-year bonds will not be the same.

 As a general rule, the interest yield on fixed-rate is higher for debt with a longer

term remaining to maturity. For example, it should normally be expected that

the interest yield on a fixed-rate bond with one year to maturity/redemption

will be lower than the yield on a similar bond with ten years remaining to

redemption. Interest rates are normally higher for longer maturities to

compensate the lender for tying up his funds for a longer time.

 When interest rates are expected to fall in the future, interest yields might vary

inversely with the remaining time to maturity. For example, the yield on a one-

year bond might be higher than the yield on a ten-year bond when rates are

expected to fall in the next few months.

 When interest rates are expected to rise in the future, the opposite might happen,

and yields on longer-dated bonds might be much higher than on shorter-dated

bonds.

Interest yields on similar debt instruments can be plotted on a graph, with the x-axis

representing the remaining term to maturity, and the y-axis showing the interest

yield. This type of graph showing the term structure of interest rates is commonly

called a yield curve.

 As indicated above, a normal yield curve slopes upwards, because interest yields

are normally higher for longer-dated debt instruments.

 However, on occasions, the yield curve might slope downwards, when it is said

to be ‘negative’ or ‘inverse’.

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 Sometimes it might slope upwards, but with an unusually steep slope (steeply

positive yield curve).

Normal (positive) yield curve Inverse (negative) yield curve

When the yield curve is inverse, this is usually an indication that the markets expect

interest rates to fall at some time in the future.

When the yield curve has a steep upward slope, this indicates that the markets

expect short-term interest rates to rise at some time in the future.

Yield curve and short-term interest rates

A yield curve can also be constructed for short-term (money market) interest rates.

For example, one-month LIBOR, two-month LIBOR, three-month LIBOR, six-month

LIBOR and one-year LIBOR might all be different. Short-term interest rates may be

upward-sloping, inverse or flat.

Risk-free rate of interest: yield curve for risk-free debt

A yield curve is often shown for risk-free longer-term debt securities. As the name

implies, risk-free debt is debt where the investor has no credit risk whatsoever,

because it is certain that the borrower will repay the debt at maturity. Debt

securities issued in their domestic currency by the government should always be

risk-free.

The interest yield on other debt securities, such as corporate bonds, is generally

higher than the yield on risk-free debt with the same maturity. For example, the

interest rate on a sterling bond of ABC Company with two-years to maturity will be

higher than the interest yield on a two-year UK government bond. The higher yield

is to compensate investors in corporate bonds for the fact that the debt is not risk-

free. The company might default.

2.2 Causes of interest rate movements

There are various factors that affect the slope of the yield curve, and that cause

changes in the yield curve.

ACCA F9 Financial Management - 2010 - Study text - Emile Woolf Publishing

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