2.5 - interest rate risk management

[2.4 - not examinable]

aim

to critically evaluate the issues and decisions that firms face regarding interest rate risk and its management

learning outcomes

by the end of this unit:

interest rates

  • definition - the price of money; the most important price in the world

  • determination - the rate at which demand for loanable funds [borrowing] equates to the supply of loanable funds [savings]

why are interest rates important?

interest rates influence key macroeconomic decisions:

  • consumption vs. saving - should individuals spend or save?

  • borrowing now vs. later - should firms/individuals borrow now or defer borrowing?

  • capital allocation - should firms hold cash, invest in CapEx, or allocate resources elsewhere?

  • duration decision - should firms borrow or lend short term or long term?

interest rates lie at the core of major financial economic decisions

corporate finance perspective

interest rates impact:

  • financing decisions:

    • debt vs. equity [long term financing]

    • loan, hire purchase, leasing [medium term financing]

    • cash vs. liquid assets [short term financing]

  • other financial topics:

    • investment appraisal - used as discount rates in NPV calculations

    • capital structure - determines cost of capital and opportunity cost

    • portfolio theory - defines the risk free rate of return

    • option pricing - used in calculating risk free return

interest rate risk

a firms financing rate is determined by:

BOE base rate + bank premium + term premium + credit risk premium

  • BOE base rate - the rate at which banks borrow from the bank of England

  • bank premium [or discount] - reflects interbank lending conditions, often referenced using SONIA [BOE base rate + bank premium]

  • term premium - the additional return required for lending over a longer duration, influenced by time value of money, inflation, and uncertainty over future base rates

  • credit risk premium - compensation for borrower default risk, which is firm-specific

fluctuations in components affect interest rate risk

  • assets - returns decrease if interest rates fall

  • liabilities - interest costs increase if rates rise

  • floating rate assets/liabilities - explicit exposure to interest rate changes

  • fixed rate asset/liabilities - no explicit risk but implicit risk arises when assets/liabilities are rolled over

  • short vs. long term borrowing:

    • short term borrowing = frequent rollovers

    • long term borrowing = higher term premiums and credit risks

interest rate risk management

interest rate risk management depends on:

  • forecasts of future interest rates

  • risk aversion of the firm

  • balance sheet structure and duration of liabilities

long term rate management = managed through capital structure decisions

short/medium term borrowers:

  • objective - remove uncertainty

  • approaches:

    • fixed rate loans

    • floating rate loans with hedges [using derivatives]

hedging instruments

  • forward-forward loans

  • forward rate agreements [FRA]

  • interest rate futures [RIF]

  • interest rate guarantees [IRG]

  • caps, floors, and collars

  • interest rate options

  • interest rate swaps

forward-forward loans

example

  • taren ltd. needs to borrow 5 mil. in 1 month for 3 months

  • expectations - interest rates will rise

  • strategy:

    • borrow 5 mil. today for 4 months at a lower rate

    • reinvest excess funds for 1 month

    • outcome - saves costs by borrowing at a cheaper rate

  • taren ltd. faces:

    • borrowing rates:

      • 2.5% = 1 month

      • 2.75% = 3 months

      • 2.75% = 4 months

    • lending rate = 2% = 1 month

calculations:

  • interest payable = 5 mil. x 2.75% x 4/12 = 45, 833

  • interest received = 5 mil. x 2% x 1/12 = 8,333

  • net interest cost = 45,833 - 8,333 = 37,500

  • annualised rate = [37,500/5 mil.] x 12/3 = 3%

forward rate agreement [FRA]

  • definition - a forward contract fixing an interest rate on a specified principal for future period

  • nature:

    • both parties agree on a fixed rate

    • notional principal - no actual money exchange

    • cash settlement - the difference between the FRA rate and actual rate is settled at maturity

    • traded over the counter [OTC]

example:

  • taren ltd. wants to borrow 5mil. in 1 month for 3 months

  • they expect borrowing rates to rise from 3% to 3.5%

  • solution:

    • borrow 5mil. at 3.5% from Bank A

    • buy an FRA from Bank B at 3%

calculations:

  • interest payable to bank A = 5mil. x 3.5% x 3/12 = 43,750

  • FRA payoff from bank B = 5mil. x [3.5% - 3%] x 3/12 = 6,250

  • net interest cost = 43,750 - 6,250 = 37,500

  • annualised interest rate on strategy:

    • [37,500/5mil.] x [12/3] = 3% — fixed no matter what happens

  • additional cost = [3.5% - 3%] x [3/12] x 5mil. = 6,250

rate index future [RIF] / short term interest rate future [STIR]

  • 3 mont interest rate futures

  • for the UK “Short Sterling Contracts“ [ST3]

  • mechanism:

    • buying the future - right to lend at a set rate for 3 months

    • selling the future - right to borrow at a set rate for 3 months

    • exchange traded - standardised, transparent, and highly liquid

example:

contract size and maturity

  • size - each futures contract represents 1mil. in notional value

  • maturity - the contract always has a 3 month duration

  • expiration dates - contracts expire in march, june, september, and december

quotation format

  • the futures price [F] is calculated using the formula:

  • therefore, if SONIA = 4.25%, then:

    • F = 100 - 4.25 = 95.75

  • this means if you buy a december contract at 95.75, you are effectively agreeing to lend at 4.255 for 3 months [april to june]

tick size and value

  • tick size - the smallest price movement is 0.005

  • value of one tick - 0.005 basis points [bps] = £12.50 per contract

    • notional value x bps = 1mil. x [0.005/100] = 50

      • must put bps out of percentage

    • contract = 3 months so its quarterly = 50/4 = 12.5

  • therefore:

    • a single tick [0.005] movement = £12.50 per contract

    • each contract has a notional value of 1,000,000

    • tick movement of 0.005 = 0.5 bps

    • so, 1 basis point = £25, and 0.5 bps = £12.50 per contract

example: buying a december 3M SONIA Futures contract

  • you buy a december contract at 95.75 [implying SONIA = 4.25%]

  • this means you have agreed to lend 1mil. at 4.25% for 3 months [april - june]

  • the contract expires in march

  • if interest rates rise:

    • assume that by expiration in march, SONIA has inc. to 5%

    • the new futures price is:

      • F = 100 - 5 = 95

    • since you bought at 95.75, and the price dropped to 95, you profit from this price movement

  • calculating profit:

    • change in price = 95.75 - 95 = 0.75 [which is 25 bps]

      • multiply out of percentage = 0.75 × 100 = 75

      • divide for 3 month contract = 75/4 = 25 bps

    • since 1 bps = £25, the profit is = £25 × 25 = £625

differences between FRA and IRF

advantages and disadvantages of FRA vs. IRF

FRA [forward rate agreement]

  • advantages:

    • easy to use, doesn’t require complex knowledge

    • customised to firm’s specific needs

    • no explicit margin requirement

  • disadvantages:

    • requires bilateral agreement with a dealer

    • no secondary market — cannot exit early

    • lack of pricing transparency

RIF [rate index future]:

  • advantages:

    • standardised and exchange traded

    • liquid secondary market — cannot exit early

    • transparent pricing

  • disadvantages:

    • requires knowledge of future markets

    • requires broker or bank access

    • requires margin deposits [initial and variation]

interest rate guarantees

opinions on interest rates

  • IRGs include caps, floors, and collars

  • traded OTC with SONIA as the underlying asset

  • short expiry dates [typically 3 months]

  • premium paid upfront for protection

borrowing with IRGs

  • if a firm expects rates to rise, it can purchase an interest rate call option

    • if rates increase — exercise call option and borrow at a lower pre-agreed rate

    • if rates decrease - do no exercise and borrow at lower market rate

    • cost - premium is paid upfront regardless of what happens

cap

  • a series of call options across different maturities

  • guarantees a maximum borrowing rate over a loan’s lifetime

  • advantage - protects against rising rates while allowing firms to benefit if rates fall

floor

  • a series of put options across different maturities

  • guarantees a minimum borrowing rate

  • disadvantage - if rates decrease, the firm still pays more

collar

  • combination of cap + floor

  • purpose - reduce hedging costs

  • the firm sells a floor [limits upside benefits] to pay for a cap [limits downside risk]

  • guarantees a range for borrowing costs

interest rate options

  • exchange traded options [e.g. 3 month short sterling options]

  • based on SONIA:

    • call option = right to deposit [lend] at a fixed rate

    • put option = right to borrow at a fixed rate

advantages and disadvantages of interest rate options

  • advan.

    • protects against downside risk

    • allows firms to benefit from favourable interest rate movements

  • disadvan.

    • premium paid upfront [cost incurred regardless of market movement]

interest rate swaps [IRS]

plain vanilla interest rate swap

  • exchange of fixed vs. floating interest payments between 2 parties

  • party A - wants to pay floating and receive fixed

  • party B - wants to pay fixed and receive floating

transforming a liability using IRS

a company can use an interest rate swap to convert its debt profile:

example:

  • company A - currently pays fixed 5.2%

  • company B - currently pays floating SONIA + 0.8%

  • swap terms:

    • company A:

      • pays SONIA [floating]

      • receives 5% fixed

      • new net rate - SONIA + 0.2% [floating liability]

    • company B:

      • pays 5% fixed

      • receives SONIA

      • new net rate - 5.8% [fixed liability]

both companies get the type of loan structure they prefer

interest rate swaps [IRS] with a bank

  • swaps are usually arranged through banks

  • banks earn 3-4 [0.03% - 0.04%] basis points for arranging offsetting transactions

  • outcome:

    • company A now pays SONIA +0.215% instead of SONIA +0.2%

    • company B now pays 5.815% instead of 5.8%

    • bank earns 3 basis points in total

comparative advantage in swaps

companies should borrow in the market where they have a comparative advantage

  • key observations:

    • company A has an advantage in the fixed rate market [lower cost]

    • company B has an advantage in the floating rate market

  • total swap gain:

    • difference in fixed - difference in floating = 1.2% - 0.7% = 0.5%

each company benefits from a 0.25% cost reductions

including a bank in the swap

if a bank is involved, it earns 10 basis points [0.1%], which is shared between both companies

discussion - IRS hedging benefitd

  • why use an IRS?

    • hedges interest rate risk effectively

    • firms get preferred interest structure [fixed vs. floating]

    • lower borrowing costs due to comparative advantage

    • good for medium term hedging [5 yrs]

  • are there disadvantages?

    • potential counterparty risk

    • complexity compared to simple loans

    • bank fees reduce the total savings