Interest Rate Risk Management and Hedging
Interest rates continue to govern our lifestyle and day-to-day activities. Almost every individual is affected by interest rates, either directly or indirectly. Interest rates define how we spend our money, expect a return on an investment, plan according to changing market trends, and make assumptions about profit and loss. Consumers and corporations closely monitor interest rates, as they have a great impact on their financial situation. Interest rate hedging has become one of the most discussed financial concepts in recent years. Interest rate hedging is essentially the practice of locking into a financial derivative to reduce the risk of volatile change in interest rates.
How Crucial is Interest Rate Hedging?
Today, interest rate hedging is considered one of the most substantial and important steps to take for any business involved with core financial activities. Analyzing risk and developing a counter strategy in advance can help you avoid losing perhaps thousands of dollars. Likewise, hedging serves as a backup in times of financial uncertainty. Many individuals, however, continue to avoid interest rate hedging because of associated costs. In the long run, saving a small amount of money can sometimes prove fatal for your business and personal wealth. Time and time again, we have seen normal and profitable operations of a corporation turn ugly because of rising interest rates, which has caused a downfall or even a cessation of business activities all because interest rate hedging/swaps is lacking.
The Role of Interest Rate Risk Management:
Interest rate risk is present when a sudden change in the market patterns of an interest rate occurs, which, in turn, affects the investments of a corporation. Thus, managing risk is a critical factor for the smooth running of any company’s operations. Normally, a sudden fluctuation in the interest rate would cause a decrease in “Net Interest Income” in the short term, while it also affects the assets of a company in the long term. Accordingly, management aims to deal with risk arising from each of these perspectives. We can further classify these as follows:
- Short-term Earning Prospect:
This involves studying change in near future incomes being generated from interest. The effects can be measured by comparing total interest income and total interest expenses.
- Long-term Economic Value Prospect:
The long-term effect of a change in interest rates is monitored by comparing a company’s cash flow for assets and liabilities. Doing this helps you to identify risk arising from long-term interest rate fluctuation.
What are Interest Rate Hedging Products and Options?
Interest rate hedging products are products/options that aim to minimize the risk associated with interest rate fluctuations. These include the following:
- Forward (FRA):
FRA (Forward Rate Agreement) is a forward contract, whereby two parties engage in a mutual agreement to minimize the risk of increased interest rates in the future. Under the contract, both parties remain locked into the agreement for a predefined period of time. At the end of the stated period, a cash settlement is carried out according to the interest rates on the current date. We can better understand FRAs by the simple example shown below.
“A” is an investor who is looking to hedge the interest rate on his future investment, while “B” is a company looking to hedge the risk of interest rate on a future loan (since it believes that an increase in interest rates is expected for the near future). “A” lends a loan amount to “B” for a period of six months at a predefined rate. At the end of six months, both parties will settle the agreement through cash. The gain or loss will be determined by comparing the decided rate against the market interest rate at the end of contract.
A future contract is another derivative that is similar to a forward contract, with the exception of the involvement of a third party. The future exchange ensures the binding of the contract for both parties at a future date.
Swaps are the most common and usually most preferred hedging products. An interest rate swap is an additional contract between two parties that allows them to exchange floating/variable rates for a more favorable fixed rate. Swaps are often considered a win-win approach for both parties dealing in different markets. Parties can often swap by using a switch of interest payments of one against the other. Swaps are good for companies/individuals looking to fix their interest rate. They help companies attain a better rate than the one being offered to them. Moreover, they allow access to global markets and help them control future cash flow.
A cap is an additional contract/derivative that helps you tackle the rising interest rate. Under such a contract, a customer will have to pay an up-front fee or a premium for the contract. As the rate fluctuates, so does the payment. If the rate shoots higher than the agreed rate, loan payments will increase, and the customer will receive additional payment from the other party.
A floor provides an investor with immediate relief in case of high interest rate fluctuation. The buyer (investor) purchases the floor from a seller. They both agree on a mutual percentage of floor rates. As the rates decline, the seller will have to pay the difference between rates.
Investors try to hedge the risk of interest rates by buying a combination of derivatives, which is termed a collar. Under this setup, the party buys a ceiling and offsets it by selling a floor. If the rate increases beyond the predefined ceiling rate, the investor will receive a payment, but if the rate goes below the floor rate, the investor will have to make a payment.
Interest Rate Shopping for Consumers:
Interest rates affect how we obtain mortgages and lease cars. Consumers are advised to keep a close watch on these rates. It is better to lock yourself in with a fixed rate for a 30-year term, while going for an ARM (adjustable rate mortgage). Doing this helps you to know the exact cost of a loan and the repayments you need to make in the future. Likewise, when consumers lease products such as cars, they should obtain fixed rates and shorter terms. The shorter the term of the loan, the lower the payments will be. However, if you are unable to make a hefty payment, you should go for a longer loan contract.
From an investor’s point of view, long-term bonds have much more risk associated with them compared with shorter investments. In such cases, if an investor is looking to sell his bonds before maturity, he will be offered a much lower price than the market price. Since long-term bonds are for a longer period of time, they are greatly affected by changing interest rates. In such cases, short-term bonds are preferred.