ACCA P4 lecture interest rate risk management overview

a PC accounting for your future hi this is Steve from a PC and in this video we are going to be started to have look at the overview of the interest rate risk management in the exam so the interest rate risk management is what we're going to think about if the interest rate rises or Falls and these will have an impact on to the compressor come please go ahead against it for example if the complaints going to borrow money from the bank instead of paying for the bag five percent but if the interest rate rises to seven percent this means they complete will end up spending extra two percent of costs into borrowing those money and there's a research of it they completely suffer loss as a result of it so company's going to figure out and anyways though we go to hedge against those risks so before we dip into the hedge of techniques over V what we are going to do firstly is what we're going to start it to have a go at the interest rate yield curve so what Bobby but interest rate you would curve is simply this we are going to use the approaches to hedge against the interest rate risk mainly for the LIBOR rate which the rates that is quoted by the bank but it does not include the credit risk premium so for example if the bank if we're going to borrow money from the bank and the bank charges seven percent so what are the same percent actually includes what includes the LIBOR rate as well as the credit risk premium so what do I mean by that for example the library is to be 5% but because the bag thing is that you're risking lending your money would mean that the company will suffer that the bank will software risk that you're not going to pay back the money at some point in future so the bank is going to do is to charge you X to 2% to compensate for the risk their code is suffering so that's a so the credit risk premia reject we can hit against that only to improve our financial performance and decrease our business risk it's all about this trilogy the company is going to use so now we are not going to use those hedging approaches such as default rate agreements such as the interest rate futures to hit against that credit risk premia because we cannot do that so we are going to do is where we're going to use those techniques or produce to hit against the library and of course the libraries can be plot into the yield curve because of many factors for example different industries that you mean different views about the inflation and it will give rise to different shape of the yield curve related to the library of course we're going to look it up when we come to it using a LIBOR rate of course we can estimate the spot rate as well as calculating the fall rate we're going to use car lock to be sophisticated mathematics to do that in the later sections related to the yield curve and once we've got the used curve the next thing being we are going to be started to look at the bond valuation so what I mean by bond valuation is that if the complaint is going to borrow some money instead of going into the bank of course the companies can borrow money from you you are the investor of course you can spend your money away to buy my bond by my corporate bond in other words if we go to buy my bond how much I should charge you if I'm going to deciding to give you 5% chests in each and every yay I'm going to give you $100 at the end of the fifth year but how much you have to pay for me how much I should borrow from you in other words starts wandering but bonfire the waiter so for example the bonfire the race is actually equals to 105 dollars this means in order for you to have 5% of inches income in each and every year you have to pay for me 105 dollars at the start otherwise you cannot enjoy those income so that's one of your bond valuations of bond valuation is all based upon the yield curve that we just look at of course we're going to use the techniques to hedge against this LIBOR rate if it rises of course it we going to borrow money from the bank we are afraid that the inches way to price so we're going to use some proaches to do that so that's come to the third part is for how we're going to hedge against the interest rate risk in this particular exam so from the exams point of view your examiner is particularly focusing on the external hedging techniques that we're going to use so the external hedge techniques can be summarized into this two aspect from the exams point of view you can either lock the raid or you can cap the rate and the two approaches they either go to lock that's a fixed rate or you're going to set a maximum that you are willing to pay for with regards to this particular page so if you decide to lock the rate of course there are many approaches in there basically there will be free approaches firstly we can use the full rate agreement so what do I mean by full range agreements is stick at far away is that you're going to enter the contract with the bag and what you're going to do is to say to the bag Wow in three months time we are going to borrow some money from you at this rate we go to agree that rate today so the October way changes in three months time we still use the rates that we obtain you agreed that's the four rate agreement so if this is the case is that good or bad of course it's good because we can fix the rate of that yes so if the interest rate rises that's nothing to do with make but what if the interpret in snow falls in three months time so we still have to use the the race that we agreed for example five percent but the interest rate falls to three percent we still have to use five percent of boils money and hence we end up with the loss so of course locking the raids if the interest rate actually force in the future we cannot benefit from those so that's the disadvantage of the forward rate agreements which they're far away the second of our way to lock the interest rate in the future is we're going to use the interest rate feature contact so what are you but interest mode feature is simply like this future of course is related to future so futures market we can think about in this way so if we are for example if we expect the interest rate will rise from 5% to 8% how we're going to do that so within the futures market we're going to bet the interest rate will rise by 3% from 5 to 8 but what if the inches we will actually rise from 5 to 8 in Fremont site so that is the case within the actual market if that particular time that the interest rate rises by 3% so of course because we've got to borrow some money from the bank so we have to end up borrow the money at 8% instead of 5% so as a result of it because in smoke rises but because we are borrowing some money because of interest rate rises and hence within the actual market where you will suffer a loss of 3% your great because instead of borrowing at 5% we now have to pay for 80% but what about for the futures market because we bets the interest rate to rise and it actually rises so my thought is correct if I'm correct I win if I win that would be the benefit of 3% that given to us that's how the fetus market actually works and why do you caste hedging is simply because we can use they income from the futures market to offset against the losses that we've incurred in the app market and hence we end up paying not fame as a result of it in increasing the interest rate but the question is why we call it estate locking into rate it's simply because for the futures market for the interest rate futures market it would be defeatist contract in March June September as well as the December and for each of his contract there would be a particular price attached to it and from an investor's point of view what we are going to do is we're going to start to entering into that contract at that particular price so that of course we can exercise that puts your contract at the fixed price that we've just entered into the price would be the interest rates that we are currently looking at here of course I'm going to go through quite a few questions like to what the next of our video about the insane future contracts in much more detail so the third why do we go to lock the racist web bugs use the interest rate swap so what do I mean by inches way swap is what I mean by interest rate exchange so we're going to exchange interest rates with another part a for example if I prefer the floating rates of the interest of example we're going to prefer the interest rate rises or Falls we're not going to fixed it so that's one with a floating rate so floating rate fixed sample we are for your think about fits so for example if you're going to borrow some money from the bank we're thinking about the interest rate may for at some point future so we go to anything to the floating rate agreement but for another party they prefer the fixed rates for example because they think that if they borrow some money they expect the interest way to rise so you're going to add Vin's accommodatin fixed interest rate at the low level so they don't have to end up with a losses at some point in the future so we tend to do is that we think that we're going to enter into a floating rate in our country it's very expensive but if I enter into a floating rate agreement in there come change the country B which is the other party it would be cheaper and vice versa so we're going to agree with each other to borrow some money so for example if I want the floating rate I borrowed the fixed rate for them and they borrow the floating rate for me and we're going to exchange with each other so example with inches way swap we will end up with the total cost is to be 5% but if we vow two inches way swap there will be a total cost of seven percent as a result of it as we so do the swap agreement we can save two percent of expenses out of it but two percent will be leading from Italy so two percent will be split between these two parties for one for me and one for him okay so that's why me about interest rate swap of course we going to look at quite a few questions related to nuts links one would come to it so with regards to the captain wrote of course there will be another freeway stopping could direct firstly we can use the interest rate guarantee to do it so inches very guarantee simply means that we going to PI the maximum of interest expenses set up by the contract for example sets in the context of maximum you're going to pay is to be 5% so even though the interest rate actually increases to 11% but you still need to pay five percents the Maxima there goes to pay for sick though we can use the interest rate option this is all based upon the inch span features market that we just look at before so what Bonnie but option is the option is the choice it is not not big Asia for example you're entering scenes like options contract and you think that if the interest rates actually rises to five percent so you will end up with the losses so you're going to do is to exercises interest rate option to entering into the interest rate of only three percent rather than five percent so if you think that the interest rate option needs to be six percent but the actual interest rate is to be seven percent so you're going to do is to go to exercise its content but if your interest rate option is seven percent but the action just right is to be six percent we've going to borrow some money of course you're not going to exercises options contract it's entirely up to you okay so in straight options contract and finally we've also got the interest rate collar hedge so what do I mean by industry call ahead is all based on the interest rate obviously contract stuff which is still cut the interest rate up to the contract you you will have that option if you give me some of the premiums so premium is along some of money such as the administration expenses but starts too expensive to perfectly honest with you so what we're going to do then is we're going to enter into the interest rate called the hedge so instead of just paying for the premium we're going to receive the premium from another party as the income to offset against those six places that we've incurred those are the instructions to the hedging techniques so but before we move any further I like to take you one step further for the summary of those hedging techniques what the approach is that we're going to use especially for the future especially for the option is actually for the interest rate called hedge because those will be examined again the getting each and every sitting and make sure that you're happy with that of course here a PC we have got our own approaches to deal with those matters they're going to use a mean monic all based upon a PC or going to swap the way around so let's think about this way firstly for the interest wave features market we're going to use the mnemonic called CPA firstly I'm going to consider the action consider the actions is where we're going to either borrow money from the others all we're going to deposit money into the bank I want to look at that of course the P it stands for the poor fee or losses from the futures market of course we're going to start working related see that okay to do the actual calculation for that and once you've done that we've got the actual cost to complain that's the process for their futures market of course we have got the options on future as well the optional future is where we're going to use your mother again it's called C P P a so firstly going to consider the option that's available such as what we've seen the features caller item again sports money or we're going to do posting on the link and then now to account for day poor for losses from the futures market so Porthos is from the futures market if this is the OTC contact which means it's not based upon the derivative market of course we're going to ignore it but if this is they this is not the OTC contact which means we're going to and spin to the interest rate options on to the actual futures market because included P&L further it's the premium car we're going to pay for in order to enter into the options contract and finally it's stick actual costs so they can play so that's the option and for the inches way collar hedge we are going to use a PC mnemonic okay quite interesting I hope so a PC stands for first leg which the actual interest rate and P stands for the premium is the premium net off against the premium that we pay at a premium that we receive from the other party but once you've done that of course we also to understand the compensation sue of from another part a because for example if we entered into the put option which is the option to sell is to be the maximums to be eight percent but the interest rate actually rises to the level percent this means that we only to pay 8% in austere bottom money from the bank and hence of course because the interest rate rises so the bank will compensate for us three percent start state see compensation to or from of course we're gonna summarize those together and that gives us the actual because we are going to deal with those bits and pieces and later questions that's a no plug for that okay so those are the waste are we going to approach the question and approach each type of his head techniques of course we got to deal with that in the later videos and that's just the introduction to the interest rate risk management and make sure that you're happy with those aspects before you go see example a PC accounting for your future

Channel: Steve ACCA/CIMA/CMA/MCSI

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Keywords: accaapc, acca, apcacca, apc acca, acca apc, acca online, acca lecture, acca online course, acca course, acca p4, acca interest rate risk management, interest rate risk management

Id: dTN_nQR87_0

Length: 20min 36sec (1236 seconds)

Published: Sat Dec 20 2014