Interest Rate Risk Management: Definition and Hedging Techniques

In this article, we will cover the interest rate risk management. This includes the overview of interest rate risk management, the key definition and interest rate hedging techniques.

Overview

All business entities acquire financing facilities from the banks and other lenders. The cost of borrowing depends on many factors including collateral, gearing, risk exposure of the business, etc. but the most important factor to determine the borrowing cost remains the interest rate. Debt financing comes with fixed and variable interest rates. The total cost of interest even with fixed interest rate borrowings will include the base interest rate + the interbank interest rate. The Federal announces the interbank interest rate from time to time considering the economic situation and the rate is subject to change.

What is Interest Rate Risk?

Business entities use financing options for both borrowing and lending. Interest rate risk is the risk of any gains or losses due to a change in the interest rate for the business. Any business having a debt facility for both variable and fixed interest rate debts will be exposed to the interest rate risks. For large businesses, the accounts receivable and accounts payable with extending time are charged for the interest rate.

Types of Interest Rate Risks

Changes in interest rate may yield gains or incur losses for the business, depending on the assets and liabilities. Any financing facility will be of two types variable interest rate based, and fixed interest rate based financing.

Variable Interest Rate Risks: The variable interest rates change often with the Federal Reserve announced an interbank interest rate. The banks may also change the variable interest rate. These changes can affect the entity’s gearing and cash flows directly.

Fixed Interest Rate Risks: A significant change from the Federal Reserve interbank interest rate change may compel the banks to change the fixed long-term financing facility. Even with a fixed interest rate, the rate at which the interest is charged can affect the profitability of the business. The business may use the hedging techniques to make the fixed interest rate facilities more competitive and less expensive.

Refinancing Interest Rate Risk:  Businesses often need to refinance the existing debt facility. In this case, the interest rate risk can arise if the business cannot refinance at the same interest rate as the existing facility.

Interest rate risks arise with both assets and liabilities for the business. If the business has made investments, any changes in the interest rate will affect the profits.

Interest Rate Risk Hedging

Financial risk can be eliminated or mitigated to an extent with different techniques. Hedging is the most widely used method for mitigating financial risks. The interest rate risks can also be managed with hedging methods. Before a business adapts to hedging methods it must consider the cost-benefits attached to it.

Important Considerations before the Hedging Decisions

Hedging reduces the risk exposure, improves the profitability and hence the competitive ranks of the business

  • Risk-averse management is likely to utilize the hedging methods which safeguards their jobs and reduces the business exposure to the financial risks
  • Risk hedges involve derivatives, the accounting and taxation skills may not be readily available with business management
  • Hedging derivatives come with different costs and still may not guarantee the full elimination of the financial risks
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Interest Rate Risk Management

Business entities need to plan for long-term especially when it comes to financial planning. Long-term project investment would rely heavily on bank borrowing facilities. If the interest rates change before the facility is availed or during the negotiations with banks, the project profitability may change considerably. A business can use two hedging methods to mitigate the interest rate risks, internal methods and external methods. In each internal and external method, there are various interest rate hedging techniques as follow:

Internal Hedging Methods

Business entities with different branches of operations and functions can adapt to restricting internally to avoid the interest rate risks. Remember, interest rate changes affect both assets and liabilities of the business. Internal methods that a business can use to reduce the interest rate risk exposure include:

Smoothing Technique

Smoothing techniques is one of the interest rate risk management strategies under the internal hedging technique. In this method, the business tries to manage the debt portfolio internally by creating a balance between variable and fixed interest rate loans. Fixed interest rate loans are often long-term facilities, and variable interest rate loans are short-term e.g. a revolving credit facility. The balance of fixed and variable interest rate debts creates a natural hedge against short-term volatilities and long-term stabilities.

Matching Technique

Matching technique is another interest rate risk management strategy under the internal hedging technique. The business pays interest on debts and earns interest through investments. The matching technique of interest rate hedging is simply the interest earned and paid comparison to match against each other. Another way of matching is to apply the same interest rate for both investing and debt facilities; either variable or fixed interest rate.

Netting Method

The last internal hedging technique is netting method. It is another interest rate risk management strategy that we use internally to manage interest rate risk. The business may use to evaluate the net benefits or costs with both investments and loans. The business may decide to keep the interest rates earned with investments higher than the interest rate payments on the debts.

Internal interest rate hedging would often involve all three methods discussed above. As for any business, adapting to any one of the methods would seem difficult in practical terms. Businesses with good finance mix both in terms of assets and liabilities, and interest rate payments and earnings, can enjoy a less risk interest rate exposure.

External Interest Rate Hedging

The business can use external hedging methods such as financial derivatives to reduce or eliminate the interest rate risks.

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Forward Rate Agreements:

Short-term bank loans often come with variable or floating interest rates. The business may face exposure to losses due to a change in the interest rate for large amounts of borrowings. Forward rate agreements or FRAs are one of the interest rate risk management strategies under the external interest rate hedging technique. FRAs are contracts between the business and the bank that allow to contractually deciding the interest rate for a future date.

Important Features of Forward Rate Agreements:

  • The interest rate is agreed upon between the lender and borrower at the time of contract i.e. the purchase of the FRA
  • The amount of the loan will be paid at the time of contract beginning date i.e. the future date agreed in the FRA contract
  • The bank normally charges a Fee for entering into an FRA contract which protects them for any losses
  • The borrower or the business gets a fixed interest rate guaranteed under an FRA, which protects them for any expensive interest rate changes
  • The borrower may sell the FRA depending on the market condition and demand for interest rate FRAs, earning profits
  • The initial pricing of the FRAs is usually higher than the normal or current interest rates to compensate the lender

Interest Rate Futures

Interest rate futures are one of the interest rate risk management strategies under the external interest rate hedging techniques. The Interest rate or any Futures are similar to the FRAs in agreements terms, provided the Futures offer more flexibility for the borrower. Interest rate Futures include both Short-term interest rate futures and long-term interest rate Futures such as for bonds. Futures are one form of Interest rate guarantees IRGs that focus on future commitment for borrowing or lending a nominated amount in a future date.

Important Features of Interest Rate Futures

  • Interest Futures are offered with a commitment for borrowing or lending the amount. The focus remains on the principal amount in pledge as well as the interest rate speculations for the coming period
  • Interest Rate futures come with standard term dates of 03 months, and can be traded on quarterly basis
  • The Futures come with standard amount for an agreed interest rate and for a three months period
  • Any gains or losses with Futures occur at the date of closing. With effective interest rate difference at the contract inception and closing date arises a gain or loss

Interest Rate Options

Interest rate options are another interest rate risk management strategy under the external interest rate hedging. As the name suggests, Interest Option offer the borrower the right to buy or sell the contract on a future date. Unlike futures and FRAs these are not commitments. The borrower usually foresees a change in the interest rate and enters into an options contract and reserves the right to exercise or let the contract lapse on the closing date.

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Important Features of Interest Rate Options

  • Option Contracts come with standard amounts for standard periods like Futures e.g. $ 0.5 million or $ 1.0 million for three months
  • The Options contracts are made for interest rates and not for the loan amount itself, hence the borrower has the right to exercise the contract or let it lapse
  • A Call option gives the holder a right to buy the future contract
  • A Put option on the other gives the right to Sell the future contract
  • Because the holder may not commit to the exercise the future contract the lenders usually charge a premium for Option higher than Futures

Interest Rate Collars, Caps, and Floors

Interest Rate Collars

The business using Options pay a premium price that can be costly. To reduce the premium prices and to minimize the losses the business may opt to use the interest rate caps. It is the method of simultaneously buying a put and selling a call option. In other words, the company protects its put option and also covers it call option. The collar creates the caps and floors in the options contract.

Interest Rate Caps and Floors

An interest rate CAP sets the maximum or upper limit for the interest rate exposure with an option contract on the execution or rollover date. These additional cover agreements come with the same standard quarterly periods and are used to set the maximum payable interest on an option contract provided the contract is executed.

The interest floors as the name suggest offer the minimum payable interest rate on put options.

Interest Rate Swaps:

In this contract both parties agree to exchange the floating and fixed interest rate payments with each other without exchanging the principal amounts. Businesses use the Swaps to hedge the interest rate risks without a change in the borrowed amount. The flexibility of the contracts makes them easy to execute, but finding the right match with the interest rate counterpart becomes difficult in the real market. Banks and financial institutes offer specialized services for premium charges to facilitate the counterparties of swaps.

Why Companies Arrange Swaps?

Lenders and creditors offer debt facilities to borrowers depending on their credit profile. The interest rates in one market could be different from the other market. Also, one company may be in a position to get a short-term loan depending on the leverage and solvency but require a long-term financing facility to fund their operations and vice versa. Swaps offer both parties the flexibility to change the interest rates without the change in principal. The principal amount remains equal for the same currency or adjusted for currency exchanges if the swap happens between two international companies.

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