Financial Risk Management and Derivative Instruments

Michael Dempsey

• Publisher: Routledge
• Year: 2021
• Print ISBN: 9780367674793
• eBook ISBN: 9781000386172
• Edition: 1
• Topic: Business
• Subtopic: Corporate Finance
• Index: Business

Financial Risk Management and Derivative Instruments offers an introduction to the riskiness of stock markets and the application of derivative instruments in managing exposure to such risk. Structured in two parts, the first part offers an introduction to stock market and bond market risk as encountered by investors seeking investment growth. The second part of the text introduces the financial derivative instruments that provide for either a reduced exposure (hedging) or an increased exposure (speculation) to market risk. The fundamental aspects of the futures and options derivative markets and the tools of the Black-Scholes model are examined.

The text sets the topics in their global context, referencing financial shocks such as Brexit and the Covid-19 pandemic. An accessible writing style is supported by pedagogical features such as key insights boxes, progressive illustrative examples and end-of-chapter tutorials. The book is supplemented by PowerPoint slides designed to assist presentation of the text material as well as providing a coherent summary of the lectures.

This textbook provides an ideal text for introductory courses to derivative instruments and financial risk management for either undergraduate, masters or MBA students.

PART B

Derivative instruments and financial engineering

5 Interest rate futures (forwards)

Pep talk for Chapter 5

We examine the more important market arrangements and instruments whereby interest rates can be swapped, speculated on, or hedged. Such instruments are used by companies seeking to exchange variable loans for fixed loans, and vice versa, as well as by financial institutions seeking to either hedge their interest rate exposure or, alternatively, speculate on future interest rates relying on their perceived superior forecasts.

Chapter revelations

1. Interest rate swaps exist to allow banks and other institutions to hedge their interest rate exposure, or, alternatively, to speculate on interest rate movements, without the need for burdensome capital upfront (as compared with, say, an investment in bonds aimed at timing interest rates).
2. In a swap arrangement, the receiver (the party receiving a fixed-rate payment stream) profits if interest rates fall and loses if interest rates rise. Conversely, the payer (the party paying fixed) profits if rates rise and loses if rates fall.
3. A bank or financial institution will seek to facilitate swap agreements with clients aimed at enhancing their borrowing positions while making a profit for itself.
4. A forward rate agreement (FRA) is an “over the counter” agreement with a financial institution that allows a firm or institution to secure a future borrowing or lending interest rate on a notional amount. The agreement provides a benefit to the firm or institution in the case that subsequent interest rates would have been less favorable to the firm or institution.
5. The existence of a regulated marketplace for the trading of “derivative” instruments whose value is dependent on subsequent interest rates allows for investors and firms to either hedge or speculate on future interest rate changes.

5.1 Introduction

Interest rates impact on the performance of commercial banks, who seek to hedge their exposure by matching the duration of their interest-bearing assets with their interest rate liabilities but who, alternatively, may seek to avail of derivative interest rate instruments that allow for constructing a position that performs in the opposite direction to their assets when interest rates change. Investment banks, firms, and financial institutions will also avail of such derivative instruments to manage their interest rate exposure. Alternatively, such institutions may seek to speculate on interest rate movements, which is to say, seek to profit, by their superior prediction of interest rate changes. Thus, for example, firms and institutions seeking to hedge their position on future interest rate movements may avail of an “over the counter” arrangement with a bank or financial institution, such as a forward rate agreement (FRA) that provides for an agreed future interest rate. Alternatively, regulated “exchanges” allow for interest rate “derivatives” to be traded in relation to future interest rates, thereby allowing for either hedging or speculating on future interest rates.

Our explanation of these instruments is developed as follows. In the following section (5.2), we introduce interest rate swaps as either a hedge or as a means of speculating on interest rate movements, and Section 5.3 considers the scenarios that allow a bank or financial institution to successfully arbitrage the needs of borrowing institutions so as to benefit these institutions while profiting for itself. Section 5.4 introduces a forward rate agreement (FRA) as a contract that allows for a firm or institution to secure a future interest rate. Sections 5.5 (Treasury bond futures) and 5.6 (interest rate futures) consider the provision of interest rate derivative instruments that are traded on regulated exchanges, and which allow for both hedging and speculation on future interest rate changes. Section 5.7 concludes.

5.2 Interest rate swaps

An interest rate swap is an agreement between two parties to exchange one stream of interest payments for another, over a set period of time. Thus, a firm required to pay at a fixed rate of interest on its received loan, might wish to exchange or swap such a commitment in return for a commitment to paying at a floating interest rate. If another company wishes to exchange its own commitment to paying at a variable rate of interest in exchange for paying at a fixed rate, the two firms may enter into a swap arrangement whereby they effectively swap their interest rate payment commitments.

Such swaps can be customized for individual needs in an “over-the-counter” (OTC) market between private parties, where they are designed by such as an investment bank to meet the particular requirements of a client. The most commonly traded and most liquid interest rate swaps are known as “vanilla” swaps, which exchange fixed-rate payments for floating-rate payments (the floating-rate is typically determined with reference to a LIBOR rate¹). Although there are other types of interest rate swaps, such as those that trade one floating rate for another, vanilla swaps comprise the vast majority of the market.

The swap contract is based on ...

Table of contents

• Cover Page
• Half-Title Page
• Series Page
• Title Page
• Copyright Page
• Dedication Page
• Contents
• List of figures
• List of tables
• Illustrative examples
• About the author
• Introduction
• Part A: Markets and uncertainty
• Part B Derivative instruments and financial engineering
• Index