CITY UNIVERSITY OF HONG KONG
DEPARTMENT OF ACCOUNTANCY
Interest Rate Risk Management
1 Interest Rate Futures
1.1 Pricing
1.2 Hedging
1.3 Speculating
2 Forward Rate Agreements (FRA)
3 Interest Rate Options
4 Interest Rate Swaps
5 Options versus Futures
1 INTEREST RATE FUTURES
In Hong Kong, 1-month and 3-month HIBOR futures and 3-year Exchange Fund Note futures
are available.
Three-month HIBOR Futures
Contract Specifications
Contract size : HK$5m
Trading month : Spot month, the next two calendar months and seven
quarterly months
Last trading date : 2 business days prior to the 3rd Wednesdays of month
Settlement date : 3rd Wednesdays of month
Settlement method : Cash
Quotation : 100 minus yield
Minimum fluctuation one basis point (0.01 of a percent) equals to HK$125
Hedging & speculating with 3-month HIBOR Futures
(1) Short Hedge
It is now 30 April; a corporate treasurer expects the company is likely to need $30
million in two months’ time for four months. He is concerned that interest rate might
increase. Currently the company can borrow at HIBOR + 0.5% and HIBOR is 5.75%.
The following 3-month HIBOR futures are available:
May 94.20
June 94.00
September 93.50
December 93.00
Determine the action the treasurer should take to establish a hedge. Estimate the
resulting interest cost if two months later, HIBOR (1) increase by 1%, (2) decrease by
1%.
1
Number of contracts required = ($30m x 4 months)/($5m x 3 months) = 8
He can sell 8 contracts of June HIBOR futures to hedge the risk and lock the interest
rate at (100% - 94%) + 0.5% = 6.5%.
The resulting interest cost will be:
(1) If interest rates increase 1% to 6.75% (Futures falls to 93.25)
Cash market borrowing cost = $30m x (6.75% + 0.5%) x 4/12 = $725,000
Futures contract gain = 8 x (9400 - 9325) x $125 = $75,000
Net borrowing cost = $725,000 - $75,000 = $650,000 or 6.5%
(2) If interest rates decrease 1% to 4.75% (Futures rise to 95.25)
Cash market borrowing cost = $30m x (4.75% + 0.5%) x 4/12 = $525,000
Futures contract loss = 8 x (9525 – 9400) x $125 = $125,000
Net borrowing cost = $525,000 + $125,000 = $650,000 or 6.5%
(2) Speculation
If an investor who believes that interest rates will decline, the strategy is to buy
interest rate futures. If interest rate decreases as expected, he then can close out the
futures at a higher value and gain from the transactions.
2 FORWARD RATE AGREEMENTS (FRA)
A forward agreement is an obligation to buy or sell a given asset on a specified date at a price
specified at the transaction date of the contract. It is negotiated privately between two parties
and so there is counterparty credit risk. In the case of an FRA, the buyer would be obligated
to “purchase” an agreed interest rate for a specified time period from a specific future
settlement date. FRAs enable those with a floating rate liability to “lock-in” a future
borrowing cost and so hedge against a rise in interest rates prior to the next loan rollover date.
(Note the difference with HIBOR futures, in which a borrower has to sell the futures to hedge
against interest rate increase.) If the interest rate is higher at the settlement date the buyer
receives the differences between the market interest rate and the agreed rate. However, if the
interest rate is lower, the buyer has to pay out the difference.
Example:
Suppose a corporate treasurer has $50 million of floating rate borrowings with rollovers
every quarter at the end of August, November, February and May. On October 31 he is
concerned about the exposure to an increase in rates on the next rollover date of November
30. The market for an FRA of “one month against four months” or “1 v 4” (i.e. a three-month
FRA in one month time) is 8.30 - 8.40 (i.e., you can deposit at 8.30% or borrow at 8.40%).
2
In the terminology of the markets, an FRA on a notional three-month deposit/loan starting in
different time (from one month to three months’ time) may be quoted as follows:
%
1v4 8.30 – 8.40
2v5 8.35 – 8.45
3v6 8.37 – 8.49
That is, the three months market rate commencing one month from now can be bought (loan)
at 8.40. The deal is done and by November 30 the three months rate has increased to 8.9%.
Buyer receives the difference payment of 8.9% - 8.4% on the principal of $50 million for 3-
months (from November 30).
That is,
$50m x (8.9% - 8.4%) x (3/12) = $62,500
(Note that the calculation of compensation will be different in different markets)
The treasurer has to rollover his loan facility at the high rate of 8.9% on November 30 but the
gain of $62,500 on the FRA means that his effective cost will be 8.4%.
The main advantage of FRAs is that they are straightforward and can be structured to specific
dates to match the underlying risk profile exactly. The disadvantage is that the market can be
very illiquid at times, as is the case in the very slowly developing market in Hong Kong, and
therefore difficult to get a good price. In addition there is a two-way credit default risk as
each party relies on the other to be able to deliver the settlement amount.
3 INTEREST RATE OPTIONS
An option is a right but not an obligation to buy (call) or sell (put) a specified asset at the
exercise price on or before the expiry date. Options may be used in a variety of ways to
reduce or minimize interest rate risk.
Interest Rate Caps
Perhaps the most common and simplest means for floating-rate borrowers to hedge against
interest rate risk is to buy an interest rate put option from the lender. This guarantees that the
interest rate will not exceed the cap rate (exercise price) for the life of the option. In other
words, the buyer of the put option is buying insurance (pays premium) against an
unfavourable interest rate movement.
3
INTEREST RATE CAP
GAIN
Exercise Price (CAP)
{ 89.00 90.50 92.00 PRICE (100-YIELD)
PREMIUM
LOSS
Borrowers may choose the level of interest rate from which they want protection. The lower
the cap level then the higher will be the put option premium. Where the market rate of
interest at settlement date exceeds the cap rate the seller of the option must compensate the
buyer for the difference. The borrower retains the potential to benefit from whatever falls in
interest rates occur.
Example:
It is now the 31st of January. The treasurer of F Company is reviewing funding requirements
and has identified the need to borrow $10 million for a period of 3 months. HIBOR is
currently 5% per year, and F Company can borrow at HIBOR + 1.5%.
The treasurer approaches a bank that can offer option contract on interest rate with the
following specifications.
Options
3-month HIBOR $5,000,000
One basis point equals $125
Exercise price Calls Puts
95.00 0.40 0.50
Determine the action the treasurer should take to establish a hedge and estimate the resulting
interest cost if HIBOR (1) increase by 1%, (2) decrease by 1%.
Number of contracts required = ($10m x 3 months)/($5m x 3 months) = 2
The treasurer should buy 2 contracts of put option. The resulting interest cost will be:
4
(1) If interest rates rise to 6% (Futures falls to 94.00)
Cash market borrowing cost = $10m x (6% + 1.5%) x 3/12 = $187,500
Option contract gain = 2 x (9500 - 9400 - 50) x $125 = $12,500
Net borrowing cost = $187,500 - $12,500 = $175,000 or 7%
(2) If interest rates fall to 4% (Futures rise to 96.00)
Cash market borrowing cost = $10m x (4% + 1.5%) x 3/12 = $137,500
Option contract loss = 2 x 50 x $125 = $12,500
Net borrowing cost = $137,500 + $12,500 = $150,000 or 6%
Interest Rate Collars
The benefits of a “cap” to a borrower are obvious but the premiums paid for this benefit may
be quite high. Besides, no one really likes paying insurance premiums to cover against
events that may never happen.
Interest rate “collars” was developed to reduce the premium payable for protection. A
“collar” involves the borrower buying a put and simultaneously selling a call option, at a
lower rate of interest (ie higher exercise price), for which he receives a premium and so
reduces the cost of protection. That is, a “collar” provides the same protection as a cap
against unfavourable interest rate movements but the potential benefit of a fall in rates is
limited by the selling of the call option.
INTEREST RATE COLLAR
GAIN
BUY PUT
90.50
92.00
LOSS COLLAR SELL CALL
Interest Rate Collar: Maximum rate (100 - 90.50) = 9.5%
Minimum rate (100 - 92.00) = 8.0%
In addition, you also incur the cost of premium = put premium – call premium
5
Example:
The ABC Ltd’s financial projections show an expected cash deficit in four months’ time of
$20 million, which will last for a period of approximately three months. HIBOR is currently
8% per year, and ABC can borrow at HIBOR + 1.5%. The treasury team believes that
inflation pressure in USA will soon force the Federal Reserve to raise USA interest rate by
1% per year, which could lead to a similar rise in Hong Kong interest rates. In Hong Kong,
the economy is still recovering from the financial turmoil and representatives of industry are
calling for interest rates to be cut by 1%.
The corporate treasury team believes that interest rate is more likely to rise than to fall. It is
now 1st of December.
The treasury team approaches a bank that can offer option contract on interest rate with the
following specifications. The bank also suggests it can offer an interest rate collar to ABC.
Options
3-month HIBOR $5,000,000
One basis point equals $125
Calls Puts
Exercise price March March
92.00 0.50 0.50
93.00 0.30 1.35
Calculate the expected interest cost based on the current HIBOR and determine the number of
contracts required for hedging.
Estimate the resulting interest cost of undertaking an interest rate cap hedge (buy put at
92.00) and an interest rate collar hedge (buy put at 92.00 and sell call at 93.00) if HIBOR (1)
increase by 1%, (2) decrease by 2%.
Current expected interest cost = $20m x (8% + 1.5%) x 3/12 = $475,000
Number of contracts required = ($20m x 3 months) / ($5m x 3 months) = 4
One basis point equals $125
Interest rate cap hedge:
(1) If interest rates rise to 9% (March Futures falls to 91.00)
Cash market borrowing cost = $20m x (9% + 1.5%) x 3/12 = $525,000
Option contract gain = 4 x (9200 - 9100 - 50) x $125 = $25,000
Net borrowing cost = $525,000 - $25,000 = $500,000 or 10%
(2) If interest rates fall to 6% (March Futures rise to 94.00)
Cash market borrowing cost = $20m x (6% + 1.5%) x 3/12 = $375,000
Option contract loss = 4 x 50 x $125 = $25,000
Net borrowing cost = $375,000 + $25,000 = $400,000 or 8%
6
Interest rate collar hedge:
(1) If interest rates rise to 9% (March Futures falls to 91.00)
Cash market borrowing cost = $525,000
Option contract gain = 4 x (9200 – 9100 – 50 + 30) x $125 = $40,000
Net borrowing cost = $525,000 - $40,000 = $485,000 or 9.7%
(2) If interest rates fall to 6% (March Futures rise to 94.00)
Cash market borrowing cost = $375,000
Option contract loss = 4 x (9400 – 9300 + 50 - 30) x $125 = $60,000
Net borrowing cost = $375,000 + $60,000 = $435,000 or 8.7%
4 INTEREST RATE SWAPS
A swap is an obligation between two counter-parties to exchange future specified cash flows
on specified dates. Swaps are classified into interest rate and foreign currency swaps.
An interest rate swap agreement is where one party pays to the counter-party a stream of
fixed rate interest payments on a specified principal and receives from the counter-party a
stream of floating rate interest payments. The rationale underlying interest rate swaps
normally derives from arbitrage opportunities that arise as a result of different perceptions of
risk and credit standing held by different markets. These different perceptions result in
different borrowers enjoying a “comparative advantage” in the fixed or floating rate interest
markets and the swap transaction can result in benefits to both parties.
For example, a semi-government corporation such as the MTRC can access Hong Kong’s
fledgling fixed rate bond market at significantly lower rates than even the more highly rated
companies. On the other hand, these companies can access floating rate funds at rates that
compare closely to those achievable by MTRC.
Interest Rate Swap
HIGHER CREDIT HIBOR LOWER CREDIT
RISK PARTY RISK PARTY
(X LTD) (MTRC)
9.5% + 0.3%
Borrow at 9.5%
HIBOR + 0.8% (to Lenders)
X Ltd. MTRC Advantage
1. Fixed rate debt 11.0% 9.5% 1.5% to MTRC
2. Floating rate debt HIBOR + 0.8% HIBOR + 0.3% 0.5% to MTRC
3. Net Comparative Advantage* 1.0%
4. Swap agreement:
7
X borrows floating: HIBOR + 0.8%
MTRC borrows fixed: 9.5%
X pays MTRC: 9.5% + 0.3%
MTRC pays X: HIBOR
5. Resulting Cost of Funds:
X Ltd: (HIBOR + 0.8) + (9.5 + 0.3) - HIBOR = 10.6% 0.4%
MTRC: 9.5 + HIBOR - (9.5 + 0.3) = HIBOR - 0.3% 0.6%
1.0%
* Even though MTRC can borrow cheaper in both markets there is still a net
comparative advantage of 1% that can be exploited to the mutual benefit of both
parties.
An interest rate swap does not involve an exchange of the principal amount and is not a form
of borrowing. Rather, it is a means of:
(a) Reducing perceived interest rate risk by switching from fixed to floating rate or vice-
versa and;
(b) Reducing the cost of borrowed funds (as described in the above example).
5 OPTIONS VERSUS FUTURES
The choice between options and futures depends upon the amount of risk the investors is
willing to take. Futures can guarantee the future cost of an asset but do not give any
participation in favourable movements in price. Options give downside protection and also
allow hedgers to participate in favourable movement but at a cost (the premium paid).
Options also allow the hedgers to fine tune their risks by choosing options with different
strike price that is not available in futures. For example, he can have smaller downside
protection by using deep “out of money” option that cost less. In this way, he will face more
downside risk but can gain more in favourable movement.
Options are also useful when future obligations of the business are unsure. Imagine a UK
firm making a takeover bid for a US company. It could lock into a $ price by selling GBP
futures but if the deal fail, the firm will be left with an open futures position that is risky. If
the firm use a GBP put option, even when the deal is unsuccessful, a put option is not as risky
as an open futures position.