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ACCA AFM | Interest Rate Hedging | Forward Rate Agreement (FRA) | Lecture 39

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Summary

Core Theme

Interest rate risk arises from potential losses due to fluctuating interest rates on assets or liabilities, and hedging strategies like Forward Rate Agreements (FRAs) are employed to minimize these risks.

Mind Map

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How do you manage

the risk financial risk associated with

interest rates?

So, so this interest rate risk remember

is about the possibility of you losing money

money

The question is why?

Because you might have an asset

that gives you income

based on interest rate.

Or you might even have a loan

borrowings. Yeah. That you have to pay interest

interest

that is also based on interest rate.

It's not impossible.

So you might some some people even

expect some payment to be made and that

payment might be tied to maybe rates or

maybe it's a late payment you get some

interest on top of it or whatever. So

whatever you have

that's exposive you to lose money

whenever interest rate changes then

that exact thing is exposing you to

interest rate risk and what you are

trying to do is to minimize that risk.

So you want to minimize it.

Which means take for instance if you

have a borrowing

that borrowing

definitely might have

an interest rate that is fixed.

And if that interest rate is fixed

then if the market interest rate reduces

which means normally you're supposed to

be paying lower if you have used market.

If they have already fixed it, you'll be

paying higher.

And the fact that you are paying higher

when you should be paying lower, you

will not be perfectly happy with that

because what you want is to always pay

The same way you might have a floating

loan that is a floating rate interest

loan where you are paying based on what

the market is saying.

So which means if the market is going up

your interest rate will be going up and

your interest expense as well will be

going up and you will not be happy at

that point you now be thinking oh had I

known I should have just fixed that rate

so that I don't have to be paying

interest rates that is very high so you

sometimes you can't tell

and that is the reason why you have to

think about edging

Because like I always tell you, edging

is not an opportunity for you to make

profit. Edging is not an opportunity for

you to make money. Edging is just a

strategy to minimize your loss.

loss.

And listen carefully is minimizing your

loss. It doesn't mean that you can

eliminate your loss.

Sometimes you might be able to depending

on your strategy but not all strategy

for edging interest rates will eliminate

it for you. But one thing for sure that

you need to know is that it doesn't stop

you from making loss. The same way it

might not stop you from making gain but

one thing you know for sure is that both

gain and losses will be very minimized

when you are edging. So what we're going

to look at now is how do we go about it?

This edging of interest rate risk. What

are the strategies? What are the

instruments that we have to use? What do

we need to do?

So we're going to look into various

strategies. Yeah. How do we manage

interest rate risk? The first thing that

I'm going to look at is the FRA which I

introduced to you briefly

when we were looking at risk management

FRA is the combination of two things.

Please take note because it's different

from your typical forward you use in currency

currency

f in forward currency all you needed to

do was just to fix the rate and you do

your transaction at that rate that's all

it's all about the FX rate but when

you're talking of FRA you're talking of

the interest rate itself

that you're trying to fix and also there

which is the road the amount that you are

are

actually trying to loan

or they are trying to invest if it's a

deposit cuz like I said in my introduction

introduction

your interest rate risk will be as a

result of either the loan that you have

or the asset that you have but both of

them are giving you value based on

interest it.

So for FRA few things I'm going to tell

you that you need to note. Yeah. And the

first thing is the fact that you need to

know when to buy or when to sell.

If you want to

pay at FRA, which means

you definitely have a loan,

you have a loan at an interest and you

think most likely in the future the loan

that you're planning to take or the loan

you currently have that is moving with

the market rate, the interest rate might

be going up. So which means when you

have a borrowing

remember your risk is always that rates

So which means you will prefer to fix

is to fix the rate so that you don't

have to pay at higher rate. You are

happy to pay at lower rate but you don't

want to pay at higher rate. So you fix

the rate.

When you fix the rate

what does that do for you? Please take

note when I buy or sell

buyers of FRA

will always remember when you buy

something you have to pay. Yeah. So that

helps you to remember buyers will pay at FRA

FRA

which means your interest will be at FRA

fixed I mean your forward rate agreement

rate and the sellers of FRA

will receive remember seller if you sell

something you will be expecting to

receive something so that helps you to

also memorize that at rate.

rate.

Yeah. So if you think about this

then you can see that if you have a

borrowing then it means that you need to

be buying FRA.

Yeah. Such that

you pay

And since sellers usually receives at

the forward rate agreement rate then you

then you should be a seller.

If you have a borrowing remember you

should be a buyer

but if you have a deposit you should be

a seller. Why should you be a seller?

cause your risk is the the fact that rates

rates

might come down. So if you know that

rates is likely going to come down, you

are happy to fix your rate and receive

at that fixed rate. So you are happy to

receive at fixed rate. So that's why if

you have a deposit then you want to be a

seller in an FRA agreement.

Very important to note this interpretation.

interpretation.

Yeah. Because

if you have a deposit which is an

investment, this is like investment.

That's what we're talking about. You're

meant to receive interest income at the

market rate or at the spot trade when

you go into that transaction in the

future. Yeah. So if you think in that

future rate would have come down then

what you want to do is to fix a rate

that your interest income will come in

the future and that's why you're using

the FRA and you are happy to fix.

So how do you know when you make

loss or profit

on FRA? That's another thing I'm talking

on under this first point of buying and

selling because when you are buying or

you are selling is for a purpose and

that is how it helps you to edge because

it is a profit or loss on your FRA that

is being added to the real transaction.

Remember what I said you always going to

have the real transaction regardless

right apart from your FRA that is on

interest rate. So which means that the

profit or loss that you're making on FRA

will be added to your actual outcome of

the transaction to really get your net

position. But how do you get your loss

or profit? One thing you need to first

of all understand is the fact that

whether you are a buyer

or you are a seller,

you will have to pay

an amount. Yeah. that is subject to the

outcome of the spot rate.

Yeah. Subject to the market rate. Yeah.

Or spot on transaction date.

And how do you know how much you are

Think about it this way.

If you are a buyer,

which is the agreed rate minus the spot.

So take for instance if

F has been agreed at 6%.

And come on the transaction date the

market rate is doing 4%.

for a buyer. A buyer must be definitely

someone that has borrowed money. So,

This person has a loan. If you have a loan

loan

and you have FRA fixed at 6% and come on

the day you want to really borrow your

money market is doing 4%.

You could see clearly that you are

disadvantaged because you could have

borrowed at 4% but unfortunately

you have borrowed at 6%.

Because you have fixed yourself at 6%.

So which means this is a loss for you.

That's why I call it you are paying. Remember

Remember

If you have to pay it means you are

making a loss.

But if you are receiving you are making

a gain. So and what how much is that

loss? F rate which is 6%

less the spot which is the market at 4%.

So you'll be paying at 2%. And you so buyer

pays at 2%.

Which means whoever sells this to him

will receive this money that the guy is paying

paying

at the same 2%.

Similarly, the same thing goes for seller

seller

but in a different direction. For a

seller, a seller will have to pay which

means a seller will be making a loss.

Yeah. Pays or making a loss

using this formula. this time around is

going to be at the spot the market rate

you are a seller which means you have a

deposit that is when you will sell

and you think rate will come down so you

And come in the future when the

transaction is about to take place the

market trade has now turned to

five let's say 6%.

Means you're going to be excited to say

yes I knew I knew the rate will come

down that is why I fixed at 7%. Look at

it market is doing 6% but it's no more

my problem because I already had a rate

fixed at 7%. And that is why if you see

how much is this guy going to pay spot

is 6%.

And FRA is 7%. So this is a negative one

in this case he's not paying negative 1.

Paying negative 1 means he's receiving

1% and that is again so it's a receipt.

So please take note.

So which means the seller receives 1% in

this scenario. And if it was the other

way around, it would have been the one

paying because by that time he fixed at 6%

and the spot is doing 7% because it's

losing and that would have been a

positive one. That's the proper payment,

proper loss. So please take note because

I don't want this negative sign start

confusing you. Just note that that is

the formula. If you're going all you

need to do is to just know one formula.

You don't need to start I mean confusing

yourself. Once you know that the buyer

is F minus spot then the seller is spot

minus FRA. Then you know that whatever

happens to the buyer opposite happens to

the seller. Like in this scenario that

I've given you now where we discover

that the seller will have to pay minus

one which is the same thing as receiving

plus one because there's nothing like

paying negative.

Receiving plus one means it is a profit

for the seller. That means the buyer of

this kind of contract is making a loss

and in that case he will pay at 1%.

Please take note that's the very first

thing you need to know about FR. You

need to know when you are buying

and when you are selling and also how

your transactions can give rise to

payment or receipt because this outcome

this outcome 1% or 2% is what you need

to add to your real interest to your

principle to get your net position. Both

of these gives you your net position of edging.

Okay,

that's the first thing you need to know.

The second thing I'm going to mention is

the quotes.

The quotes

that you are used to

under FX

the FX tricks that we just finished is

different from the kind of code you will

see here. And also you might be thinking

maybe the code to be like 5% 3%

like that but I'm going to get there.

The first thing I'm going to tell you

first of all is the fact that it has a

nomenclature a naming system that starts with

with

the time between now and when the

transaction is going to take place.

So take for instance if today is year zero

zero

and let's say this is January that's

today let's say January 1st year zero today

if you are looking to have a transaction

in 3 months

which means

March 31st

You want to sign an agreement.

The question is this loan agreement that

you are planning to sign in March. Yeah.

for the loan. Yeah. If the ten of that

loan is 6 months. So this is 6 months

and the delay is 3 months.

So today you are thinking of a

transaction that will occur in the

future which is a signing of a loan

agreement and that loan will be a six

What you are saying there is when you're

looking for quotes this is going to be

quoted as

because the the the edging period

remember is 3 months. That's where you

start from because this is today that

you're saying okay I don't know what the

rate will be by the time I'm signing

this loan in 3 months time. So I want to

do FR today to manage the risk of that

future. So which means I'm starting with

3 months

then dash

I know that this loan tenor is 6 month.

It's not going to be -6 because that is

a common mistake I've seen looking I

mean making instead because three months

already gone plus another six

is 9. So that's 6 + 3 then that means

what you are looking for is 3-9 F. So by

time we get into calculation and you are

seeing different

FR coded you should be able to identify

the right FR code. you should be using

because imagine in this transaction they

give you a quote say okay maybe 5% to 3%

then you have another one 3 to 8 fra

they give you maybe 3 to six or 4 to 8

like that like that you should know that

all these ones are noises and they're

nothing you should be using

right the quote for 3-9 is what has to

be relevant for you the other way is

they might also say 3 versus 9

is the same thing they are saying

whether they put dash or they put V

is the same thing.

The next thing you need to note about

how this is different is the way the

which you might probably have seen an

idea here.

You remember when we're doing currency

we always say there's a buy rate and

there's a sell rate.

And we believe that bank will always

sell at a higher rate than the buy rates.

rates.

That is for currency.

you need to understand the way the quote

is slightly different

and it's not that the principle is

different. The principle is still the

same thing. And what is the principle?

The principle is that the bank will

always make money on the transaction.

And which means if bank will always make money

money

on the transaction,

it means that bank will make sure that

when people give them money,

they pay

interest on that money.

that is much cheaper than the interest

that they will pay when they are giving

that same money out to people. So what

am I saying? Naturally what you will see

is that in interest rate quotes usually

you will see it looking like the higher

rate is being written first and the

lower rate is written after.

But whichever the case you see, the

bottom line is that you must know that

the bank will

will pay

pay

for investing which is people that are

giving their deposit to bank.

We pay a lower rate for

let me put it to investors so that it's

clear lower rates to investors whereas

whereas

higher rates from

So investors are like the lenders the

people that give their money to the bank.

bank.

So which means if you see a quote like

this means that 5%

is the borrowing rate and 3% is the

before I move on any question at this

So what we are saying

invariably is that when you have a borrowing

what is your risk

your exposure is that you don't want

Anybody that have borings will be so

And if you have deposit,

the problem is that you want to make

money and you will be having sleepless

And if you are exposed [snorts] to any

of this

and you want to use a far then

then

that is what we want to learn right now.

But remember what I said anytime you are

thinking of FRA you need to remember that

that

it is a combination of the FRA itself

which is the rate you're trying to agree

for the future plus the loan itself the principle

principle remember

remember

very important it's

it's

only when you have that combination that

you can actually say okay you are edging

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