1. MANAGING INTEREST RATE RISK

2. THEORIES OF INTEREST RATE DETERMINATION Expectation theory : –Forward interest rate are representative of expected future interest rates  shape of the yield curve reflects market’s expectation

3. THEORIES OF INTEREST RATE DETERMINATION Liquidity theory : –Investors will choose longer term maturities as long as additional yield compensates the lack of liquidity  forward interest rates possess a liquidity premium as well as future interest rate expectation

4. THEORIES OF INTEREST RATE DETERMINATION Preferred habitat theory : –Investors who habitually prefers a certain investment horizon can be convinced to change maturity horizon by giving an appropriate premium  shape of the yield curve also depends on policies of market participants

5. THEORIES OF INTEREST RATE DETERMINATION Market segmentation theory : –Different investors have different time horizon due to nature of their business or as a result of investment restrictions  shape of the yield curve is also influenced by investors compositions

6. FACTORS THAT AFFECT INTEREST RATES Expected levels of inflation General economic conditions Monetary policy and the stance of the central bank Foreign exchange market activity Foreign investor demand for debt outstanding Financial and political stability

7. SOURCE OF INTEREST RATE RISK Changes in the level of interest rates  Absolute Interest Rate Risk Changes in the shape of the yield curve  Yield Curve Risk Mismatches between exposure and the risk management strategies undertaken  Basis Risk Risk of availability of similar or better investment opportunities at the end of investment duration  Refunding Risk

8. ABSOLUTE INTEREST RATE RISK The possibility of change in interest rate The longer the duration, the higher the risk of interest rate change Can be hedged operationally or using instruments

9. YIELD CURVE RISK

10. BASIS RISK Unavailability of hedge instrument for specific needs Some knock out features incorporated in the hedge instrument

11. REFUNDING RISK Inability to forecast interest rate at maturity of a loan or investment Callable bonds Mismatch of investment duration vs financing duration

12. FORWARD RATE AGRREMENT A forward rate agreement (FRA) is a forward contract in which one party pays a fixed interest rate, and receives a floating interest rate equal to a reference rate (the underlying rate).

13. FORWARD RATE AGREEMENT Over the counter agreement to receive or pay interest for a certain period starting from the agreed time Consist of FRA rate & Reference Rate Forward term is the time prior to the beginning of FRA Contract term is the period covered Settlement is usually at forward term/ beginning of contract term, usually discounted Maturity is the end of contract term A borrower buys an FRA to protect against rising interest rates A lender sells an FRA to protect against declining interest rates The payer of the fixed interest rate is also known as the borrower or the buyer, whilst the receiver of the fixed interest rate is the lender or the seller.

14. FORWARD RATE AGREEMENT 3 X 6 FRA at 10.00%  FRA begins in 3 months time for a period of 6 months with a confirmed rate of 10.00% per annum

15. FORWARD RATE AGREEMENT REFERENCE RATE (LIBOR) FRA RATE (FIXED) LENDER / SELLER PAY FLOATING BORROWER / BUYER PAY FIX 8.00 %10.00 %Receives 10.00% Pays 8.00% Pays 10.00 % Receives 8.00% 11.00 %10.00 %Receives 10.00% Pays 11.00% Pays 10.00 % Receives 11.00%

16. PAYOFF FORMULA

17. INTEREST RATE FUTURES Exchange traded forwards No credit line needed

18. BOND FUTURES Guarantees the future holder a certain price for a respective bond. Used to hedge bond and interest rate risk, change portfolio asset allocation or alter portfolio duration Bond issuer can hedge by buying bond futures to sell If interest rates increases ( bond prices falls), bond futures value increase If interest rates declines ( bond prices increases), bond futures value decline but has been offset by bond price increase

19. INTEREST RATE SWAP Cy A Bank/Bond X Cy B Bank/Bond Y floatingfixed floating fixed Payments are done by calculating the differentials

20. INTEREST RATE SWAPS Over the counter transaction between counterparties Interchanging of rates, e.g. fixed vs floating  Fixed rate quotation : –Term of swap :……years –Bank bid-offer: 4.25% – 5.35% Exchanging floating to fixed  receive floating, pay fixed  take bank offer rate Exchanging fixed to floating  receive fixed, pay floating  take bank bid rate

21. INTEREST RATE SWAP Cy A Floating rate lenders Cy B Eurobonds LIBOR + 0.5% 6.50% Intermediary Bank 5.35%4.25% LIBOR

22. Floating A$ Interest LIBOR +1.25% Fixed US$ Interest At 5.5% Deutsche Bank Interest flows Fixed US$ Interest At 6% CROSS CURENCY & INTEREST RATE SWAP Company A Deutsche Bank Initial exchange 4/2008 Bank of Commonwealth Swap with Notional Deposit A$ 200 Mio Facility US$ 170 Mio Swap Counterparty Interest Flows for US$ 170 Mio loan Deutsche Bank final exchange 4/2013 A$ 200 Mio proceeds A$ 200 Mio US$ 1 = A$ 1.1125 US$ 178 Mio US$ 170 Mio US$ 160 Mio US$ 1 = A$ 1.25 A$ 200 Mio US$ 170 Mio A$ 200 Mio Fixed US$ Interest at 5.25% Floating A$ Interest LIBOR+1.28% Floating A$ Interest LIBOR + 1.5% Floating A$ Interest LIBOR + 2.5% ANZ transact Swap Contract, Starting spot FX A$ 200 Mio Floating rate Bond Due 4/2013 ANZ transact Forward in accord To Swap contract Swap Counterparty Interest Flows for A$ 200 Mio deposit

23. ZERO COUPON SWAP Cy A Bank/Bond X Swap issuer floating Zero Coupon Payments are done by cy A at the end of swap term

24. Floating A$ Interest LIBOR +2% Deutsche Bank Interest flows Baloon amount of US$ 80 Mio CROSS CURENCY & ZERO COUPON SWAP Company A Deutsche Bank Initial exchange 4/2008 Bank of Commonwealth Deposit A$ 200 Mio A$ Debtor Interest Flows Deutsche Bank final exchange 4/2013 A$ 200 Mio proceeds A$ 125 Mio US$ 1 = A$ 1.1125 US$ 113 Mio US$ 110 Mio US$ 100 Mio US$ 1 = A$ 1.25 A$ 200 Mio US$ 110 Mio A$ 200 Mio Floating A$ Interest LIBOR+1.5% Floating A$ Interest LIBOR + 2.5% Floating A$ Interest LIBOR + 2.5% ANZ transact Swap Contract, Starting spot FX A$ 200 Mio Floating rate Bond Due 4/2013 ANZ transact Forward in accord To Swap contract A$ 200 Mio US$ 60 Mio A$ 200 Mio

25. FORWARD INTEREST RATE SWAPS Arranging a swap in advance of its requirements and commencement

26. CLOSING OUT AN IRS Offset the swap with another that will produce the required payments stream Cancel the existing swap by paying or receiving a lump sum (NPV of remaining payments) Extend the swap Sell the swap to another party if possible

27. INTEREST RATE OPTIONS CAPS –A series of interest rate options (caplets) to protect against rising interest rates. –European style –At the expiry date of each caplets, the cap seller reimburse the cap buyer for the difference if reference rate > strike rate

28. INTEREST RATE CAP CAP = 14% REF. RATE = 17% REF. RATE = 5% Receive 3 % if loan(buyer), Pay 3% if deposit (issuer) Option not exercised BUY A CAP : option for maximum interest for loan ; ISSUE A CAP : issuing rights for maximum interest to be paid

29. INTEREST RATE OPTIONS FLOORS –A series of interest rate options (caplets) to protect against falling interest rates. –European style –At the expiry date of each caplets, the cap seller reimburse the cap buyer for the difference if reference rate < strike rate –Alternative of buying a cap is selling a floor

30. INTEREST RATE FLOORS FLOOR = 8% REF. RATE = 17% REF. RATE = 5% Option not exercised Pay 3% if loan (issuer), Receive 3% if deposit (buyer) BUY A FLOOR : option for minimum interest for deposit ; ISSUE A FLOOR : issuing rights for minimum interest to be received

31. INTEREST RATE COLLARS Comprises a cap and a floor, whereby one is purchased and the other one sold Purchased options provides protection against adverse interest movements Sold options provides income to offset premium paid for purchased options European style Zero cost collar : –premium payment for an option = premium received from the other option

32. INTEREST RATE COLLARS for DEPOSIT ISSUE A CAP = 14% BUY A FLOOR = 8% REF. RATE = 17% REF. RATE = 5% Pay 3 % Option not exercised Receive 3%

33. INTEREST RATE COLLARS for LOAN BUY A CAP = 14% SELL A FLOOR = 8% REF. RATE = 17% REF. RATE = 5% Receive 3 % Option not exercised Pay 3%

34. SWAPTIONS Options on Interest Rate Swaps Payer swaptions : gives the option holders the right to pay fix and receive floating Receiver swaptions : gives the option holders the right to receive fix and pay floating

35. ASSET – LIABILITY MANAGEMENT Gap management : –matches duration of assets to liabilities, eg account payables to account receivables