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copyright anbirts1 Definition of Risk Variability of Possible Returns Or The Chance That The Outcome Will Not Be As Expected

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copyright anbirts2 Interest Rate Risk The risk of loss of interest revenue that occurs when interest rates change, through the mismatch of re-pricing of assets and liabilities.

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copyright anbirts3 Interest Rate Risk Measuring Impact Gap analysis Duration (later) Example 4 year loan, USD 9,000,000 Current interest rate 8% Amortised by 8 equal semi annual payments of principal

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copyright anbirts4 Interest Rate Risk - Gap Analysis (1)At 12% interest and 80% forecast op profit (2) at 10% interest and 80% forecast op profit Months0-66-1212-1818-2424-3030-3636-4242-48 Principal90007875675056254500337522501125 i @ 8%3653192732281821379146 + Principal14901444139813531307126212161171 Op profit15981597159815971598 15971598 I @ 10%45639934228522817111457 + Principal15811524146714101353129612391182 i @ 12%54747941134227320513768 + Principal16721604153614671398133012621193 Op profit15981597159815971598159715981597 Short Fall(78)(7)62130200267336404 (1) Op Profit127912781279127812791278 Short Fall(393)(326)(257)(189)(119)(52)1686 (2) Op Profit Short Fall(302)(246)(188)(132)(74)(18)3997

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copyright anbirts5 Interest Rate Risk Instruments Forward Forward Money Financial Futures Forward Rate Agreement Interest Rate Swap Interest Rate Options

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copyright anbirts6 Forward Forward Money Situation: Need to borrow GBP 1,000,000 from 30 days time for 30 days Current Interest Rate 1 month 3-3½ 2 month 3¾-4 Borrowing Spread ¼% Action: Borrow for 2 months at 4¼%, Deposit for 1 month at 3% Borrow today GBP 997,540.31 and Deposit for 1 month 997,540.31 x.03 x 30/365 = 2,459.69 = 1,000,000 in total at T30 Cost of Borrowing: 997,540.31 x.0425 x 60/365 = 6969.12 Total to Repay at 60 days = 1,004,509.43 Effective Cost of Borrowing = 4,509.43 x 365/30 = 5.4865 from T30-T60 1,000,000

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copyright anbirts7 Financial Futures Definition A term used to designate the standardised contracts covering the purchase or sale of an agricultural commodity e.g. corn, commodity e.g. oil, foreign currency or financial instrument for future delivery on an organised futures exchange

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8 Financial Futures An Example Three Month Eurodollar Interest Rate Future Unit of Trading USD 1,000,000 Delivery/Expiry Months March, June, September, December and four serial months, such that 24 delivery months are available for trading, with the nearest six delivery months being consecutive calendar months Delivery /Expiry Day First business day after last trading day Last Trading Day11.00 Two business days prior to third Wednesday of delivery month Quotation100.00 minus rate of interest Minimum Price Movement (tick size & value) 0.01 (USD 25) Initial Margin (Straddle Margin) USD 625 (USD 200) Trading hours08.30 – 16.00

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copyright anbirts9 Financial Futures Example Date: 21 st October 2009 Situation: USD 1,000,000 due November 21 st 2009 Intention: Invest three month on interbank market Problem: Expect rates to fall from current rate of 2 % Questions 1)Will you buy or sell futures? 2)How many?

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copyright anbirts10 Financial Futures Example Action Today Today in the Futures Market: Buy one December contract at 98.1 (100 -1.9%) Note: at todays rate of 2 % USD 1,000,000 would earn 1,000,000 x.02 x 90/360 = 5,000

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copyright anbirts11 Financial Futures Example Action on 21st November In cash market, arrange three month deposit of USD at current rate of 1.5 % 1,000,000 x.015 x 90/360 = 3,750 This equals a loss of 1,250 over 2% rate Sell the future for 98.6 (100 -1.4)

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copyright anbirts12 Financial Futures Example Net Result 1,000,000 x.015 x 90/360 = 3,750 Bought Future at 98.10 Sold Future at 98.60 Gain 50 basis points At USD 25 per tick =1,250 = 5,000

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copyright anbirts13 Financial Futures Example Question? Why have we managed a perfect hedge? i.e. ended up with USD 1,005,000 at end of deposit? Note: the cash price moved from 2 to 1.5 A movement of 50 basis points The futures price also moved by 50 basis points exactly offsetting the loss on the cash market

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copyright anbirts14 Financial Futures Example Will this always be so? No Cash market Futures market Today Expiry Basis

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copyright anbirts15 Financial Futures Example So what if held to expiry? Cash market = 1.5 therefore futures price would be 98.50 But bought at 98.10 Gain 40 basis points Therefore net result = 40 x 25 = 1,000 Plus interest earned at 1.5 = 3,750 Total 4,750 So effective interest = 4,750/1,000,000 x 360/90 x 100 = 1.9%

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copyright anbirts16 Forward Rate Agreements (FRAs) An agreement between two parties to compensate one another, in cash, on a certain date for the effect of any subsequent movement in market rates in respect of a future interest period.

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copyright anbirts17 FRA Example Need to borrow GBP 1,000,000 in 30 days time for 30 days. Worried rates will rise. Rate Agreed 5 1/8 (5.125) Actual Rate On Day T30 5 1/4 Compensation amount paid by Bank to Company 1,000,000 x.05125 x 30/365 = 4,212.33 1,000,000 x.0525 x 30/365 = 4,315.07 = 102.74 = 102.74 = 102.30 1 + (.0525 x 30/365 ) QuotePeriodRate 1-25-5 1/8 1-45 1/8 -5 1/4 3-125 1/4 -5 3/8

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copyright anbirts18 Test 1,000,000, - 102.30 = 999,897.70 999,897.70 x.0525 x 30/365 = 4,314.63 Less Compensation Amount = 102.30 Total Net Interest Paid 4,212.33

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copyright anbirts19 Interest Rate Swap Comparative Advantage FixedFloating AAA8Libor + 1/4 BBB10Libor + 1/2 Difference2 1/4 Benefit1 3/4

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copyright anbirts20 8 1/2 L -(L + ½ ) +(L) -8 1/2 Net –9.0 AAA -(8) + 8. 1/2 -L Net – (L – 1/2 ) Benefit ¾ + 1 1 3/4 BBB 8 1/2 L -(L + ½ ) +(L) -8 1/2 Net –9.0

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copyright anbirts21 Interest Rate Swap AAA -(8) + 8.5 1/2 -L Net – (L – 1/2 ) 1/4 ¾ 1 3/4 Benefit Bank 8 1/2 L -(L + ½ ) +(L) -8 3/4 –9 1/4 BBB L 8 3/4 + 1/4

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copyright anbirts22 Interest Rate Cap or Ceiling Agreement An interest rate cap is an agreement between the seller or provider of the cap and the borrower to limit the borrowers floating interest rate to a specified level for an agreed period of time. For the investor substitute floor and investor above.

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copyright anbirts23 Interest Rate Cap Effective Interest Rate Cap: 5 Years, 6 Mo Rollover, Strike Price 7%, Premium 225 per million

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copyright anbirts24 Interest Rate Collar Agreements An interest rate collar is an agreement whereby the seller or provider of the collar agrees to limit the borrower/investors floating interest rate to a band limited by a specified ceiling rate and floor rate.

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copyright anbirts25 Interest Rate Collar Collar: 5 year, 6 Mo Rollover, Zero Premium, Strike Prices 7% and 3%

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copyright anbirts26 Duration You have a bond, life 5 years with annual interest payments of 8%, face value GBP 1,000 What is your problem? Market Price Risk Re-Investment Rate Risk

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copyright anbirts27 Duration Duration gives an average life of the cash flows of an instrument by weighting the Net Present Values of the cash flows by their timing. Cash FlowYearNPVNPV x Y 80174.07 80268.59137.18 80363.51190.53 80458.80235.20 10805735.033675.15 1,0004,312.13

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copyright anbirts28 Duration Duration = 4,312.13 = 4.31 years 1,000 Known as Macauley Duration

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copyright anbirts29 Uses of Duration Immunisation Wish to fix yield on a portfolio of bonds regardless of whether interest rates go up or down. Done by creating a portfolio of bonds with a Duration equal to the required period.

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copyright anbirts30 Uses of Duration Price Sensitivity Modified Duration which is Macauley Duration (1 + y/n) Wherey = yield n = number of discounting periods 4.31 = 3.99 (1.08) Or increase in the market interest rate of 1% will lead to a drop in the value of the bond of approximately 3.99%.

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