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Greetings Tutor. I hope you are doing well.
Can you help me with the following questionWhich TWO of the following statements concerning the interest rate risk management method of smoothing are true?
A) The debt portfolio will consist of a mixture of fixed and floating rate debt.
B) Interest payments will still increase if the interest rate rises..
C) Investments with a fixed cash flow will be financed with fixed rate debt.
D) Full benefit will be obtained from a fall in interest rates.
E) The net effect will be an interest payment which is fixed overall.Correct Option are A&B.
Can you explain me why Option B is correct and also why Option E is incorrect.Option B is correct because, under the smoothing method, even if a portion of the debt is at a fixed rate, the variable rate portion will still incur higher interest payments if interest rates rise. Therefore, the overall interest payments will increase due to the variable rate debt.
Option E is incorrect because the smoothing method does not guarantee that the net effect will be a fixed overall interest payment. Since the debt portfolio consists of both fixed and floating rate debt, the total interest payments will vary depending on the performance of the floating rate portion, which can lead to fluctuations in the overall interest payments.
Thank you. Tutor finally understood
There’s another question I’d like to ask.
Q) Which of the following
statements is/are correct?
1 Smoothing is an interest rate risk hedging technique which involves maintaining
a balance between fixed-rate and floating-rate debt2) Asset and liability management can hedge interest rate risk by matching the
maturity of assets and liabilities.In Statement 2, the examiner States the statement is true. But isn’t this statement incomplete? As we should match not just the maturity (term) of Assets and liabilities, but also the rate of interest? Or can the intrest rate be different?
For the very first question that I asked you.
Can we say that Option E (The net effect will be an interest payment which is fixed overall) is more relevant to Matching (With no Positive or Negative gap) and not Smoothing. However the exception to my very own statement could be the Basis Risk? As the base for calculating Floating Intrest on Borrowings and Deposits might be differentIn answer to the first question
Option E is incorrect because the net effect of smoothing does not guarantee that the overall interest payment will be fixed. Smoothing aims to balance the exposure to interest rate fluctuations by using a mix of fixed and floating rate debt, but it does not eliminate variability in interest payments. Therefore, while it may reduce the impact of interest rate changes, it does not ensure a fixed overall payment.
Your observation about Option E being more relevant to Matching is valid. Matching focuses on aligning cash flows and interest payments to minimise interest rate risk, which can lead to a more stable payment structure. Basis risk, as you mentioned, can indeed affect the relationship between floating interest rates on borrowings and deposits, adding another layer of complexity to interest rate management strategies.
Thec2nd question
Statement 2 is indeed true as it highlights the concept of asset and liability management in hedging interest rate risk by matching the maturity of assets and liabilities. However, your observation about the statement being incomplete is valid.
While matching the maturity is a crucial aspect, it effectively considers the interest rates of the assets and liabilities. Ideally, the interest rates should be aligned to minimise the risk of interest rate fluctuations affecting cash flows. Therefore in essence the statement does not encompass the full scope of interest rate matching, which includes both maturity and interest rate alignment.
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