Interest Rate Risk - Management of Market Risk

Discussion in 'SP9' started by Dar_Shan0209, Feb 28, 2021.

  1. Dar_Shan0209

    Dar_Shan0209 Ton up Member

    Hi tutors,

    From the Core Reading, i understand that there are 2 types of interest rate risk: Direct and Indirect. To hedge direct exposure we make use of FRA and caps/floors of interest rates. For indirect exposure we make use of cashflow matching, immunisation and hedging using model points. Page 26 talks about interest rate swaps and swaption. I reckon that these are 2 another ways to hedge interest rate risks, but do they fall under direct exposure or under indirect exposure? I kind of agree if it would be an indirect exposure given we might need to enter into swaps for future payments linked to LIBOR for e.g. but just thinking whether it can be under direct exposure as well?

    Thanks
     
    Last edited: Feb 28, 2021
    Dar_Shan0209, Feb 28, 2021
    #1
  2. David Wilmot

    David Wilmot ActEd Tutor Staff Member

    Hi Darshan,

    Interesting question. Here's my thinking on this ...

    By managing direct interest rate risk, indirect interest rate risk is managed too - in the sense that if the size of cashflows are managed then the value of cashflows has also been managed. The reverse is not true, i.e. managing indirect interest rate risk does not necessarily manage direct interest rate risk.

    A swap can be considered as being equivalent to a series of forward rate agreements. Hence swaps can be used to manage direct interest rate risk.

    A swaption is an option to enter into a swap. As such, just as for options on interest rates (caps and floors), a swaption can also be used to manage direct interest rate risk.

    Do you agree with my thinking?

    Kind regards

    David
     
    David Wilmot, Mar 1, 2021
    #2
  3. Dar_Shan0209

    Dar_Shan0209 Ton up Member

    Thanks David - definitely makes sense!
     
    Dar_Shan0209, Mar 2, 2021
    #3

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