Interest rate risk hedging can arise due to fluctuation in interest rates. Macroeconomic factors affect the interest rates. Central Banks change interest rates from time to time that can directly affect the borrowers and investors.
Individuals and corporate customers are prone to interest rate risks alike. Also, interest rates can occur for investors as well as borrowers that can be seen as a competitive disadvantage in the long run.
There are several techniques for interest rate risk hedging, which individuals and businesses can imply to mitigate these risks. Matching, smoothing, Futures, FRAs, and several other contract types are used for interest rate risk hedging.
What are Interest Rate Risks?
Interest rate risks are potential losses due to a change in the interest rates. For investors in fixed income instruments such as bonds, an increase in interest rate will decrease the value of the underlying instrument. Similarly, borrowers with variable interest rate borrowings are prone to higher borrowing costs.
Borrowers with fixed-interest rate instruments and investors can also face risks due to a decrease in the interest rates. Borrowers and investors can be at a competitive risk as lower interest rate securities become available in the market.
What is Interest Rate Risk Hedging?
Hedging is a technique to offset the risks of adverse interest rate movement effects on a financial instrument. It is usually taken with an opposite position to one financial position to offset the damages or take advantage of favorable positions.
Interest rate hedging can be planned for investors and borrowers. Both face interest rate risks with varying effects. Borrowers look to capitalize on lower interest rates and investors would seek higher interest rates for maximum benefits.
Although it is possible to make profits or maximize gains with interest rate hedging, it is not always possible to do so. For instance, a borrower would like to seek the lowest possible interest rates for reduced borrowing costs, however, that can be practically impossible to achieve. Hence, hedging can mitigate interest rate risks but cannot eliminate them.
Interest Rate Risk Hedging for Borrowers
Dealing with banks for taking loans or fixed deposits requires different hedging techniques than investments in stock markets such as bonds. The aim for borrowers or investors with banks should be to mitigate the adverse interest rate risk movements.
Smoothing is one of the simplest hedging methods. Borrowers would need to spread out the loan amount into different segments with variable and fixed interest rates. In case of an interest rate increase, only the variable interest rate loans will be affected. Similarly, if the interest rates fall, only the fixed-interest rate loans will get affected.
The smoothing technique can be applied for deposits with banks as well.
Businesses can hedge against interest rate risks with matching securities as well. In this approach, a business would need to match the assets and liabilities with the same type of interest rate. For example, if a business has a bank loan with a variable interest rate, it can deposit with the bank with a variable interest rate borrowing.
Suppose the current LIBOR is 2%. A borrower has a loan with a variable interest rate of LIBOR + 4%. It has a deposit rate of LIBOR + 2%. Suppose both amounts are $ 100,000.
Borrowing cost = $ 100,000 × (2+4) % = $ 6,000.
Deposit Income = $ 100,000 × (2+2) % = $ 4,000
Net Cost = $ 2,000.
Suppose the LIBOR increased from 2% to 4%.
Borrowing cost = $ 100,000 × (4+4) % = $ 8,000.
Deposit Income = $ 100,000 × (4+2) % = $ 6,000
Net Cost = $ 2,000.
Net cost can be different if the loan and fixed deposit amounts are different.
Interest Rate Risk Hedging for Investors
Investors can use simpler smoothing or matching techniques as well. However, there are several other techniques that investors should consider.
Investors can make forward interest rate contracts to avoid adverse interest rate movement. In a forward contract, the borrower locks an interest rate for a certain period with the lender.
Forward Rate Agreements – FRAs
FRAs are similar to Forwards with more formalities. FRAs are made between two parties with opposite interest rate risks. For example, an investor with a fixed interest rate investment would seek a variable interest rate investor to make an FRA. When the interest rate moves, there is always a net effect for both sides. The gainer with FRA pays to the loser.
Futures contracts are similar to forward with more formalities and legal protection for investors. Future contracts also offer a decided interest rate for a specified amount and dates. These contracts are offered through third-party intermediaries.
SWAPS work like FRAs as both parties exchange the varying interest rates for the same amount of investments. An investor with a floating rate pays interest with a fixed rate and receives the floating interest rate, while the other party pays a floating rate and receives a fixed rate.
Advantages of Interest Rate Risk Hedging
There are several advantages of interest rate hedging:
- It protects buyers and investors from adverse interest rate movement effects.
- It minimizes losses on borrowings and loans.
- It can enable investors to take advantage of favorable interest rate movements.
- It helps investors and borrowers to overcome macroeconomic downturns.
Disadvantages of Interest Rate Risk Hedging
Hedging can turn out to be risky as well, hence comes with some disadvantages.
- It cannot fully eliminate the losses.
- Predictions for interest rate movements cannot be made accurately.
- Hedging costs can overweigh potential profits with a favorable interest rate movement as well.
Hedging involves arranging investments or borrowings to mitigate adverse interest rate movements. Borrowers and investors can use different techniques to minimize losses. However, hedging does not guarantee favorable returns always.