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 (futures)

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 (futures)

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

Traded interest rate options

• Option to enter into a futures contract

• Holder has the right but not the obligation to enter into a futures contract

• Holder can take advantage of favourable interest rate changes whilst protecting against averse interest rate movements

To hedge against a rise in interest rates when borrowing (options)

A company will set up the hedge by buying a put option on a futures contract (i.e. a right to sell a futures contract); it will then close out the hedge by buying a futures contract

To hedge against a fall in interest rates when depositing (options)

A company will set up the hedge by buying a call option on a futures contract (i.e. right to buy a futures contract); it will close out the hedge by selling a futures contract

Caps

• Sets a maximum amount of interest that is payable when a company borrows money

• A type of option

• Can be purchased from a bank for a premium

Ways of creating a cap using IRGs instead of purchasing directly from bank

• Company buys a call option on an FRA (i.e. purchase the right to buy an FRA)

• Company buys a put option on an interest rate future (i.e. purchase the right to sell an interest rate future)

Floor

• A floor is a minimum amount of interest that is receivable when a company invests or deposits money

• A type of option

• Can be purchased from a bank for a premium

Creating a floor using IRGs

• Buy a put option on an FRA (i.e. purchase the right to sell an FRA)

• Buy a call option on an interest rate future (i.e. purchase the right to buy an interest rate future)

Collars

• The interest rate is pegged between two levels, i.e. a cap and a floor

• Premium payable for a collar is significantly lower than the payable for a cap (when borrowing) and a floor (when depositing)

Creating a collar with IRGs - borrowing

• Buy a call option on an FRA and sell a put option on an FRA

• Buy a put option on a future and sell a call option on a future

Creating a collar with IRGs - depositing

• Buy a put option on an FRA and sell a call option on an FRA

• Buy a call option on a future and sell a put option on a future

Interest rate swaps

• Transactions which allow a company to exploit different interest rates in different markets for borrowing, reducing or altering the timing of interest payments

Two types of swaps

• A swap between two companies (bank may act as an intermediary)

• A swap between a company and a bank

Company with a fixed rate commitment, which believes that interest rates are about to fall

swaps with a counterparty with a floating rate commitment, which believe that interest rates are about to increase

They still retain their obligations to the original lenders, so there is a degree of counterparty risk, as if the other party defaults on interest payments the original borrower remains liable to the lender

Benefits of swaps

• Company can obtain interest rates which are lower than directly from a bank or other investors

• May be able to structure the timing of payments so as to better match cash outflows with revenues

• Easy to organise and flexible as can be arranged in any si`e

• May also be reversible by negotiation

Disadvantages of interest rate swaps

• Bank will charge a fee

• Position risk - risk arises from changing type of debt i.e. swap fixed to floating and rates end up rising

• Counterparty risk - the risk that the counterparty will default in their obligations

• Transparency risk - risk that the financial statements do not show a true + fair view to the basic user

Cross currency swaps

• Allows a company to swap a currency it currently holds for a different currency for a fixed period, and then swap back at the same rate at the end of the period

Characteristics of a cross currency swap

• 2 elements

  • exchange of principles in different currencies swapped at original spot rate

  • exchange of interest rates - timing depending on individual contact

• Could be fixed for fixed, floating for floating or fixed for floating

• Company will end up with the currency it needs and type of interest it prefers (fixed or floating)

Advantages of cross currency swaps

• Useful for changing currency profile of debt

• Help reduce overall interest costs - particularly if difficult to obtain finance in foreign country

• Help to manage currency risk across the organisation

Disadvantages of cross currency swaps

• Counterparty risk is high

  • Different currencies

  • Final principle exchanged