Managing Interest Rate Risk - Using Financial Derivatives

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.

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.

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