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Hi tutor,
Sorry- I’ve watched your lectures on interest rate risk management but im still confused about interest rate options and interest rate guarantee.
Are interest rate options and guarantee the same? I know guarantee consists of a cap and a floor and these are options but I read an article on ACCA website and it said that interest rate options are taken out on futures contracts (that they are used together) and it then further talked about interest rate guarantee in a different paragraph like the two were unrelated to each other.
I have another question as well, on the asset beta formula. If a company is investing in a new business with purely equity finance, do we need to regear the ungeared asset beta? If we do not need to, then why is that so?
Hope you could help me on these, thank you 🙂
Interest rate options and interest rate guarantees have the same end result in that they create either a cap if you are borrowing money, or alternatively a floor if you are investing money.
However they work differently. An IRG is a ‘private’ deal with the bank and and they agree to fix a limit directly.
Traded options work in a completely different way and are options to buy or sell futures at a fixed price. The details of how traded options work are not examinable until Paper P4 (to be safe be aware they exist, but that is all). (The problem with some of the articles on the ACCA website is that they are relevant for more than one paper, but not all of the content is always relevant for the lower paper.)The only reason that the geared beta (which measure the risk of a share) differs from the asset beta (which is the risk of the business) is because of gearing – if there is gearing in the business then the shares are more risky and the beta would therefore be higher.
If there is no gearing then the equity beta is the same as the asset beta. (And if you look at the formula, if the debt is zero, then again the asset and equity betas will be the same.)
I’m glad the details of traded options wouldn’t be tested. Thanks for the clarification!
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