Risk Management: Interest Rates
Hedging is important due to the size of potential losses from adverse interest rate movements
Interest rate risk depends on interest rate volatility, gearing and floating rate exposure
Companies mat be exposed to interest rate risk for loans they already hold, or future loans they are considering
Companies with significant floating rate debt are concerned about interest rate increases
Companies with a lot of fixed rate debt may lose competitive advantage if interest rates fail.
Internal Risk Management
Smoothing
Hedging interest rate risk by maintaining a balance of fixed rate and floating rate debt
If interest rates rise, lower cost of fixed rate debt offset higher cost of floating rate debt.
If interest rates fall, lower cost of floating rate debt offsets higher cost of fixed rate debt
Matching
Hedging interest rate risk by matching assets and liabilities with a common interest ratef
Commercial companies do not normally have interest-bearing assets that are comparable with their interest bearing liabilities
Commonly used by banks, which receive large amount of income from loans and also borrow... HOWEVER
Basis risk arises if floating rates on assets and liabilities have a different basis. Based on LIBOR
Gap exposure arises if floating rates on the same basis are revised over different periods. When do variable rates roll over?
Forward Rate Agreement
Forward contract fixing future interest rate for agreed period on an agreed principal amount.
If interest rate on execution date is adverse compared with contract rate, banks will pay compensation to the company for loss.
Company pays bank if opposite is the case
Company neither gains nor loses if interest rate change i.e. an effective fixed rate loan
This actual loan may be taken out with a different provider
Interest rate options
Futures
Companies buy interest rate futures to hedge an interest rate fall and SELL futures to hedge an interest rate rise
A common future is the 3 month £500,000 LIBOR sterling contract
Interest rate futures are priced by subtracting the interest rate from 100, an index price.
Value of a contract is the tick value - 1 basis point
A basis point is 0.01 per cent of the contract - a small movement in rates
Futures position closed out by opposite trade
Advantages
Risk reduction since rates "locked in"
Returns "marked to market"
Readily trade-able since standardised
Can be traded away
Prices are "transparent" market prices
No upfront premium like options
Disadvantages
Imperfect hedging leads to over - or under-hedging
Cannot take advantage of favourable rates
Basis risk
The interest rate may not exactly match the change in the contract price
Give holder the right but not obligations to borrow or lend at a given rate
Option premium paid when option is bought
Traded options are bought and sold on the financial markets
Over the counter options are sold by banks and are tailored to customers' needs
Caps, Floors and Collars
Over the counter options
Tailored to client needs as regards size and duration and cannot be traded as a result
Classified as
Caps (guarantees maximum rate)
Floors (guarantees minimum rate)
Collars or cylinders (fixes rate between limits)
Caps and collars allow long term hedging of interest rate risk - over 18 months
Interest rate cap
Sets a maximum borrowing rate for the holder
The seller of the cap (bank) compensates the buyer (company) if interest rates rise above the cap rate
The compensation payment is assessed each time the interest rate changes on a rollover date e.g. every 6 months
The cap is an option since it limits exposure to large increases in interest rates but the firm can still take advantage of lower interest rates
For the luxury of the option to cap its interest rate a substantial premium will be paid to the bank.
Interest Rate collar
A collar is so much cheaper than a cap
Collar agreement keeps borrowing rates within an upper and lower limit - combination of cap and floor
The holder of an interest rate floor in guaranteed a minimum interest rate receipt on interest income
The firm sells a bank an interest rate floor to guarantee the bank gets paid a minimum rate of interest
The firm compensates the bank for any movement in interst rates below the floor rate.
Interest Rate Swaps
An exchange of one stream of future cash flows for another stream of future cash flows with different characteristics.
Swaps are used extensively by banks and companies for heding interest rate over long time periods
Banks intermediate by warehousing swaps until counterparty is found