Interest rate risk management

Bank’s lending rate quoted to customer

is always higher than the depositing rate, as the bank wants to make a profit

i.e.

• borrowing 10k - 5% interest rate

• 10k savings - 2% interest rate

3% profit margin

Internal methods of interest rate risk management

• Smoothing - mix of fixed rate and floating rate borrowing

• Matching - match type of borrowing with type of deposit, i.e. bank: mortgage - asset (floating), matched with savings - liability (also floating)

• Netting - net off all interest payable with interest receivable

External methods of interest rate risk management

• Forward rate agreements (FRAs)

• Interest rate guarantees (IRGs)

• Interest rate futures

• Options on interest rate futures

• Collars, caps, floors

• Interest rate swaps

Forward Rate Agreements (FRAs)

• A forward contract on an interest rate for a future short-term loan or deposit

• Can be used to fix the interest rate on a loan or deposit starting at a date in the future

• A contract that fixes a short-term interest rate, such as a 3-month ‘risk free rate’ or 6-month ‘risk free rate’. FRAs are normally for amounts of more than 1 million.

• FRA doesn’t replace the original loan/deposit - it’s a combination of the loan/deposit and the settlement of the FRA that gives the effective fixed rate

To hedge against a rise in interest rates when borrowing

a company will buy an FRA

To hedge against a fall in interest rates when depositing

a company will sell an FRA

FRA on a notional 3 month loan/deposit starting in four months’ time

4 - 7 FRA (starts in 4 months and finishes in 7 months, span of 3 months)

Interest Rate Guarantee (IRG)

• An option to enter into an FRA contract

• More expensive than an FRA (a premium is payable)

• Allows holder to protect against adverse interest rate changes whilst at the same time take advantage of favourable interest rate changes

If a company wishes to borrow money and is worried about a rise in interest rates

It would hedge the rise by buying an FRA - the IRG would be a call option (right to buy an FRA) (buy to borrow)

If a company wishes to deposit money and is worried about a fall in interest rates

It would hedge the fall by selling an FRA. The IRG would be a put option (right to sell an FRA) (sell to deposit)

Two types of interest rate futures

• Short-term interest rate futures (3 months duration)

• Bond futures (longer term)

As they are tradable

Futures are more standardised, and therefore bought/sold in set quantities and will have a fixed execution date.

Usually the end of March, June, September or December.

Futures contracts themselves

are closed out for cash, so can be used to offset any gain/loss on interest rates changing

To hedge against a rise in interest rates when borrowing

A company will set up the hedge by selling a futures contract, and close out the hedge by buying a futures contract

To hedge against a fall in interest rates when depositing

A company will set up the hedge by buying a futures contract, and close out the hedge by selling a futures contract

Futures contracts are always priced at 100 less the interest rate

If the interest rate is 8%, the price of the futures will be 100 - 8 = 92