Hedging techniques for interest rate risk
This article looks at Section G of the Financial Management Study Guide relating to the management of interest rate risk.
Section G of the Financial Management Study Guide specifies the following relating to the management of interest rate risk:
(a) Discuss and apply traditional and basic methods of interest rate risk management, including:
(i) matching and smoothing
(ii) asset and liability management
(iii) forward rate agreements
(b) Identify the main types of interest rate derivatives used to hedge interest rate risk and explain how they are used in hedging.
(No numerical questions will be set on this topic)
The cause of interest rate risk
Risk arises for businesses when they do not know what is going to happen in the future, so obviously there is risk attached to many business decisions and activities. Interest rate risk arises when businesses do not know:
(i) how much interest they might have to pay on borrowings, either already made or planned, or
(ii) how much interest they might earn on deposits, either already made or planned.
If the business does not know its future interest payments or earnings, then it cannot complete a cash flow forecast accurately. It will have less confidence in its project appraisal decisions because changes in interest rates may alter the weighted average cost of capital and the outcome of net present value calculations.
There is, of course, always a risk that if a business had committed itself to variable rate borrowings when interest rates were low, a rise in interest rates might not be sustainable by the business and then liquidation becomes a possibility.
Note carefully that the primary aim of interest rate risk management (and indeed foreign currency risk management) is not to guarantee a business the best possible outcome, such as the lowest interest rate it would ever have to pay. The primary aim is to limit the uncertainty for the business so that it can plan with greater confidence.
Traditional and basic approaches
Matching and smoothing
When taking out a loan or depositing money, businesses will often have a choice of variable or fixed rates of interest. Variable rates are sometimes known as floating rates and they are usually set with reference to a benchmark such as LIBOR, the London Interbank Offered Rate. For example, variable rate might be set at LIBOR +3%.
If fixed rates are available then there is no risk from interest rate increases: a $2m loan at a fixed interest rate of 5% per year will cost $100,000 per year. Although a fixed interest loan would protect a business from interest rates increases, it will not allow the business to benefit from interest rates decreases and a business could find itself locked into high interest costs when interest rates are falling and thereby losing competitive advantage.
Similarly if a fixed rate deposit were made a business could be locked into disappointing returns.
Smoothing
In this simple approach to interest rate risk management the loans or deposits are simply divided so that some are fixed rate and some are variable rate. Looking at borrowings, if interest rates rise, only the variable rate loans will cost more and this will have less impact than if all borrowings had been at variable rate. Deposits can be similarly smoothed.
There is no particular science about this. The business would look at what it could afford, its assessment of interest rate movements and divide its loans or deposits as it thought best.
Matching
This approach requires a business to have both assets and liabilities with the same kind of interest rate. The closer the two amounts the better.
For example, let’s say that the deposit rate of interest is LIBOR + 1% and the borrowing rate is LIBOR + 4%, and that $500,000 is deposited and $520,000 borrowed. Assume that LIBOR is currently 3%.
Currently:
Annual interest paid = $520,000 x (3 + 4)/100 = $36,400
Annual interest received = $500,000 x (3 + 1)/100 = $20,000
Net cost = $16,400
Now assume that LIBOR rises by 2% to 5%.
New interest amounts:
Annual interest paid = $520,000 x (5 + 4)/100 = $46,800
Annual interest received = $500,000 x (5 + 1)/100 = $30,000
Net cost = $16,800
The increase in interest paid has been almost exactly offset by the increase in interest received. The extra $400 relates to the mismatch of the borrowing and deposit of $20,000 x increase in LIBOR of 2% = $20,000 x 2/100 = $400.
Asset and liability management
This relates to the periods or durations for which loans (liabilities) and deposits (assets) last. The issues raised are not confined to variable rate arrangements because a company can face difficulties where amounts subject to fixed interest rates or earnings mature at different times.
Say, for example, that a company borrows using a ten-year mortgage on a new property at a fixed rate of 6% per year. The property is then let for five years at a rent that yields 8% per year. All is well for five years but then a new lease has to be arranged. If rental yields have fallen to 5% per year, the company will start to lose money.
It would have been wiser to match the loan period to the lease period so that the company could benefit from lower interest rates – if they occur.
Forward rate agreements (FRA)
These arrangements effectively allow a business to borrow or deposit funds as though it had agreed a rate which will apply for a period of time. The period could, for example start in three months’ time and last for nine months after that. Such an FRA would be termed a 3 – 12 agreement because is starts in three months and ends after 12 months. Note that both parts of the timing definition start from the current time.
The loans or deposits can be with one financial institution and the FRA can be with an entirely different one, but the net outcome should provide the business with a target, fixed rate of interest. This is achieved by compensating amounts either being paid to or received from the supplier of the FRA, depending on how interest rates have moved.
Example:
Nero Co’s cash flow forecast shows that it will have to borrow $2m from Goodfellow’s Bank in four months’ time for a period of three months. The company fears that by the time the loan is taken out, interest rates will have risen. The current interest rate is 5% and this is offered by Helpy Bank on the required FRA.
Required
(i) What kind of FRA is needed?
(ii) What are the cash flows if the interest rate has risen to 6.5% when the loan is taken out?
(iii) What are the cash flows if the interest rate has fallen to 4% when the loan is taken out?
(i) The FRA needed would be a 4 – 7 FRA at 5%
(ii) If the interest rate has risen to 6.5%:
| $ | |
|---|---|
| Interest on loan paid by Nero Co to Goodfellow’s bank = $2m x 6.5/100 x 3/12 = |
(32,500) |
| Paid to Nero Co under FRA by Helpy Bank = $2m x (6.5 – 5)/100 x 3/12 = |
7,500 |
| Net cost of the loan to Nero Co | (25,000) |
(iii) If the interest rate has fallen to 4%:
| $ | |
|---|---|
| Interest on loan paid by Nero Co to Goodfellow’s bank = $2m x 4/100 x 3/12 = |
(20,000) |
| Paid by Nero Co under FRA to Helpy Bank= $2m x (4 – 5)/100 x 3/12 = |
5,000 |
| Net cost of the loan to Nero Co | (25,000) |
Note:
(a) In both cases the effective rate of interest to Nero Co on the loan is 5%, the FRA-agreed rate: $2m x 5/100 x 3/12 = $25,000.
(b) In part (iii) when interest rates have fallen, Nero Co would no doubt wish that it had not entered the FRA so that it would not have to pay Helpy Bank $5,000. However, the purpose of the FRA is to provide certainty, not to guarantee the lowest possible cost of borrowing to Nero Co and so $5,000 will have to be paid to Helpy Bank.
Interest rate derivatives
The interest rate derivatives that will be discussed are:
(i) Interest rate futures
(ii) Interest rate options
(iii) Interest rate caps, floors and collars
(iv) Interest rate swaps
Interest rate futures
Futures contracts are of fixed sizes and for given durations. They give their owners the right to earn interest at a given rate, or the obligation to pay interest at a given rate.
Selling a future creates the obligation to borrow money and the obligation to pay interest
Buying a future creates the obligation to deposit money and the right to receive interest.
Interest rate futures can be bought and sold on exchanges such as Intercontinental Exchange (ICE) Futures Europe.
The price of futures contracts depends on the prevailing rate of interest and it is crucial to understand that as interest rates rise, the market price of futures contracts falls.
Think about that and it will make sense: say that a particular futures contract allows borrowers and lenders to pay or receive interest at 5%, which is the current market rate of interest available. Now imagine that the market rate of interest rises to 6%. The 5% futures contract has become less attractive to buy because depositors can earn 6% at the market rate but only 5% under the futures contract. The price of the futures contract must fall.
Similarly, borrowers will now have to pay 6% but if they sell the future contract they have to pay at only 5%, so the market will have many sellers and this reduces the selling price until a buyer-seller equilibrium price is reached.
- A rise in interest rates reduces futures prices.
- A fall in interest rates increases futures prices.
In practice, futures price movements do not move perfectly with interest rates so there are some imperfections in the mechanism. This is known as basis risk.
The approach used with futures to hedge interest rates depends on two parallel transactions:
- Borrow/deposit at the market rates
- Buy and sell futures in such a way that any gain that the profit or loss on the futures deals compensates for the loss or gain on the interest payments.
Borrowing or depositing can therefore be protected as follows:
Depositing and earning interest
The depositor fears that interest rates will fall as this will reduce income.
If interest rates fall, futures prices will rise, so buy futures contracts now (at the relatively low price) and sell later (at the higher price). The gain on futures can be used to offset the lower interest earned.
Of course, if interest rates rise the deposit will earn more, but a loss will be made on the futures contracts (bought at a relatively high price then sold at a lower price).
As with FRAs, the objective is not to produce the best possible outcome, but to produce an outcome where the interest earned plus the profit or loss on the futures deals is stable.
Borrowing and paying interest
The borrower fears that interest rates will rise as this will increase expense.
If interest rates rise, futures prices will fall, so sell futures contracts now (at the relatively high price) and buy later (at the lower price). The gain on futures can be used to offset the lower interest earned.
Students are often puzzled by how you can sell something before you have bought it. Simply remember that you don’t have to deliver the contract when you sell it: it is a contract to be fulfilled in the future and it can be completed by buying in the future.
Of course, if interest rates fall the loan will cost less, but a loss will be made on the futures contracts (sold at a relatively low price then bought at a higher price).
Once again, the aim is stability of the combined cash flows.
Summary
The summary rule for interest rate futures is:
- Depositing: buy futures then sell
- Borrowing: sell futures then buy
Interest rate options
Interest rate options allow businesses to protect themselves against adverse interest rate movements while allowing them to benefit from favourable movements. They are also known as interest rate guarantees. Options are like insurance policies:
- You pay a premium to take out the protection. This is non-returnable whether or not you make use of the protection.
- If interest rates move in an unfavourable direction you can call on the insurance.
- If interest rates move favourable you ignore the insurance.
Options are taken on interest rate futures contracts and they give the holder the right, but not the obligation, either to buy the futures or sell the futures at an agreed price at an agreed date.
Using options when borrowing
As explained above, if using simple futures contracts the business would sell futures now then buy later.
When using options, the borrower takes out an option to sell futures contracts at today’s price (or another agreed price). Let’s say that price is 95. An option to sell is known as a put option (think about putting something up for sale).
If interest rates rise the futures contract price will fall, let’s say to 93. Therefore the borrower will buy at 93 and will then choose to exercise the option by exercising their right to sell at 95. The gain on the options is used to offset the extra interest that has to be paid.
If interest rates fall the futures contract price will rise, let’s say to 97. Clearly, the borrower would not buy at 97 then exercise the option to sell at 95, so the option is allowed to lapse and the business will simply benefit from the lower interest rate.
Using options when depositing
As explained above, if using simple futures contracts the business would buy futures now and then sell later.
When using options, the investor takes out an option to buy futures contracts at today’s price (or another agreed price). Let’s say that price is 95. An option to buy is known as a call option.
If interest rates fall the futures contract price will rise, let’s say to 97. The investor would therefore sell at 97 then exercise the option to buy at 95. The gain on the options is used to offset the lower interest that has been earned.
If interest rates rise the futures contract price will fall, let’s say to 93. Clearly, the investor would not sell futures at 93 and exercise the option by insisting on their right to sell at 95. The option is allowed to lapse and the investor enjoys extra income form the higher interest rate.
Options therefore give borrowers and lenders a way of guaranteeing minimum income or maximum costs whilst leaving the door open to the possibility of higher income or lower costs. These ‘heads I win, tails you lose’ benefits have to be paid for and a non-returnable premium has to be paid up front to acquire the options.
Interest rate caps, floors and collars
Interest rate cap:
A cap involves using interest rate options to set a maximum interest rate for borrowers. If the actual interest rate is lower, the option is allowed to lapse.
Interest rate floors:
A floor involves using interest rate options to set a minimum interest rate for investors. If the actual interest rate is higher the investor will let the option lapse.
Interest rate collar:
A collar involves using interest rate options to confine the interest paid or earned within a pre-determined range. A borrower would buy a cap and sell a floor, thereby offsetting the cost of buying a cap against the premium received by selling a floor. A depositor would buy a floor and sell a cap.
Interest rate swaps
Interest rate swaps allow companies to exchange interest payments on an agreed notional amount for an agreed period of time. Swaps may be used to hedge against adverse interest rate movements or to achieve a desired balanced between fixed and variable rate debt.
Interest rate swaps allow both counterparties to benefit from the interest payment exchange by obtaining better borrowing rates than they are offered by a bank.
Interest rate swaps are arranged by a financial intermediary such as a bank, so the counterparties may never meet. However, the obligation to meet the original interest payments remains with the original borrower if a counterparty defaults, but this counterparty risk is reduced or eliminated if a financial intermediary arranges the swap.
The most common type of swap involves exchanging fixed interest payments for variable interest payments on the same notional amount. This is known as a plain vanilla swap.
Interest rate swaps allow companies to hedge over a longer period of time than other interest rate derivatives, but do not allow companies to benefit from favourable movements in interest rates.
Another form of swap is a currency swap, which is also an interest rate swap. Currency swaps are used to exchange interest payments and the principal amounts in different currencies over an agreed period of time. They can be used to eliminate transaction risk on foreign currency loans. An example would be a swap that exchanges fixed rate dollar debt for fixed rate euro debt.
