INTEREST RATE
RISK
Allan Cris D. Ricafort | 15 Oct 2022
LEARNING OBJECTIVES
♦ Identify opportunities to reduce interest rate
exposure
♦ Evaluate ways to manage interest rate risk with
forward rate agreements, futures, and swaps
♦ Assess the use of interest rate options, including
swaptions
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introduction
♦ Although the business of hedging usually
involves derivatives, it is possible to rearrange
activities to minimize interest rate exposure.
♦ Depending on its approach, an organization can
supplement internal hedging strategies with
interest rate derivatives such as forward rate
agreements, futures, swaps, and options.
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RISK EXPOSURE
REDUCTION
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Risk Exposure Reduction
The following techniques have been used to reduce interest rate exposure and the
resulting need for derivatives:
♦ Global cash netting/inhouse bank
♦ Intercompany lending
♦ Embedded options in debt
♦ Changes to payment schedules
♦ Asset–liability management
Although it might be possible to manage interest rate exposure without derivatives,
legal, tax, and regulatory ramifications must be taken into consideration, particularly in
foreign countries or for cross-border transactions. These may prohibit such
transactions or reduce or eliminate the benefit.
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Global Cash Netting
♦ When an organization has cash flows in multiple currencies,
some parts of the organization may have excess cash while
others may need to draw down on available lines of credit.
♦ A cash forecast for specific currencies will enable surpluses
and shortages to be forecast and managed more accurately.
♦ On a centralized basis, it may be possible to pool funds from
divisions or subsidiaries and make them available to other
parts of the organization.
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Intercompany Lending
♦ When one part of an organization requires long-term
funding, and another part has excess cash available for
investment purposes, the combination of the two may reduce
interest costs and permit more control over the borrowing
process.
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Embedded Options
♦ The use of debt securities with features such as a call
provision provides debt issuers with an alternative method
for managing exposure to interest rates.
♦ If interest rates decline, the issuer can retire the higher-
interest debt through the call provision and subsequently
reissue lower-interest debt.
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Changes to Payment Schedules
♦ Changes to payment schedules may permit an organization to
maintain cash balances for longer periods, reducing the need
for funding and therefore exposure to interest rates
Changes to supplier/vendor payment schedules
Changes to customer payment schedules
Changes to contractual long-term payments
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Asset–Liability Management
♦ Asset–liability management involves the pairing or
matching of assets (customer loans and mortgages in
the case of a financial institution) and liabilities
(customer deposits) so that changes in interest rates do
not adversely impact the organization.
♦ This practice is commonly known as gap management
and often involves duration matching.
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MANAGING
INTEREST RATE RISK
Forward Rate Agreements
Interest Rate Futures
Interest Rate Swaps
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Forward Rate Agreements
♦ A forward rate agreement (FRA) is an over-the-
counter agreement between two parties, similar to a
futures contract, to lock in an interest rate for a short
period of time.
The period is typically one month or three months,
beginning at a future date.
♦ A borrower buys an FRA to protect against rising
interest rates, while a lender sells an FRA to protect
against declining interest rates.
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Forward Rate Agreements
♦ An FRA is an agreement between the Bank and a
Customer to pay or receive the difference (called
settlement money) between an agreed fixed rate (FRA
rate) and the interest rate prevailing on stipulated
future date (the fixing date) based on a notional
amount for an agreed period (the contract period).
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Calculating an FRA Settlement Amount
A company needs to borrow $10 million in three months’ time. Management is concerned that rates may rise, so the
company buys a 3 x 6 FRA at 4.00 percent. The term 3 x 6 indicates that the FRA term begins three months from the
trade date and ends six months from the trade date (a term of three months).
If interest rates have risen (as measured by the reference rate compared with the FRA rate), the bank will compensate
the company. If the reference rate has fallen, the company will compensate the bank.
FRA rate 4.00%
Reference (actual) rate 5.00%
Difference 1.00%
1.00% x 90 days/360 days x $10 million = $25,000
Since the settlement amount is usually paid at the beginning of the period covered by the FRA, the
amount is discounted and its present value paid ($24,691.36) to the company.
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Forward Rate Agreements
♦ FRAs can be closed out at current market value. Since
both parties have an obligation under an FRA, closing
out the contract involves unwinding it through an
offsetting transaction.
♦ The buyer of an FRA will sell an offsetting FRA, while
the seller of an FRA will buy an offsetting FRA, with a
resultant gain or loss.
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Interest Rate Futures
♦ Interest rate futures are exchange-traded forwards. They
permit an organization to manage exposure to interest rates
or fixed income prices by locking in a price or rate for a
future date.
♦ Transacted through a broker, there are commissions to buy or
sell and margin requirements.
♦ Unlike FRAs, there is no need to establish a line of credit
with a bank. The risk of dealing with other counterparties is
replaced with exposure to the exchange clearinghouse.
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Interest Rate Futures
♦ Interest rate futures are exchange-traded forwards. They permit an
organization to manage exposure to interest rates or fixed income
prices by locking in a price or rate for a future date.
♦ Transacted through a broker, there are commissions to buy or sell and
margin requirements.
♦ Unlike FRAs, there is no need to establish a line of credit with a bank.
The risk of dealing with other counterparties is replaced with
exposure to the exchange clearinghouse.
♦ Interest rate futures may be based on a benchmark interest rate, index,
or fixed income instrument.
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Bond Futures
♦ Bond futures allow investors to hedge existing bond
positions, or to replicate bond positions, without
buying or selling the underlying bonds.
♦ They are useful for tactical asset allocation strategies
employed by professional money and portfolio
managers.
♦ They can assist in the management of exposure to
long-term interest rates.
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Bond Futures
♦ A borrower can protect against rising rates by selling a bond
futures contract provided that the contract underlying
interest is similar to the exposure.
♦ If interest rates rise (underlying bond price falls), the gain
on the futures contract should offset higher market interest
rates.
♦ The advantages of using bond futures as a proxy to actual
purchases of bonds include ease of execution and delivery
and potential for reduced transaction costs.
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Interest Rate Swaps
♦ Interest rate swaps are related to forwards and futures but facilitate
interest rate hedging over a longer time interval.
Common swaps include asset swaps, basis swaps, zero-coupon swaps, and
forward interest rate swaps.
♦ The swap is an agreement between two parties to exchange their
respective cash flows. This involves a fixed rate payment exchanged
for a floating rate payment.
♦ Both parties are obligated by the swap’s conditions, and thus there may
be a cost to exit from an existing swap, depending on how rates have
changed since it was transacted.
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Interest Rate Swaps
♦ Borrowers with weaker credit ratings may face a credit premium
for fixed rate borrowing. Such an organization may borrow at
relatively more attractive floating rates and swap for the desired
fixed rate payments without any change to the underlying debt.
♦ When interest rates are expected to fall, market participants move
to floating interest rates, and there is downward pressure on swap
spreads. When interest rates are expected to rise, market
participants will move to borrow at fixed interest rates, putting
upward pressure on swap spreads.
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Asset Swaps
♦ A swap to transform an asset’s income stream
♦ The most popular asset swaps are those that change
payments from a fixed interest rate to a floating
interest rate, and those that exchange a cash inflow in
one currency to another currency.
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Basis Swaps
♦ Basis swaps enable counterparties to change exposure
from one benchmark floating rate to another.
♦ Basis swaps can also be used to exploit favorable
interest rate differentials between indices, or in
anticipation of interest rate movements, while
maintaining exposure to floating interest rates.
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Zero-Coupon Swaps
♦ Zero-coupon bonds consist of one payment at maturity
comprising principal plus all interest.
♦ With no coupon payments, zero-coupon bonds eliminate
reinvestment risk for coupon income.
♦ Zero-coupon financing can be desirable but difficult to
obtain from a lender, so an alternative is to borrow in another
cost-effective way and use a zero-coupon swap to
synthetically create the zero-coupon debt.
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Forward Interest Rate Swaps
♦ allow hedgers to arrange a swap in advance of its requirement
and commencement.
♦ Forward interest rate swaps also allow borrowers and
investors to alter cash flows in anticipation of future changes
in interest rates or the yield curve.
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Interest Rate Swaps
♦ Interest rate swaps must be settled at market
value to be terminated.
♦ The market value of a swap at any time after its
commencement is the net present value of future
cash flows between the counterparties.
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Interest Rate Swaps
There are several ways to alter or eliminate an existing interest
rate swap:
♦ Offset the swap with another that will produce the required payment
streams.
♦ Cancel the existing swap by paying or receiving a lump sum
representing the net present value of remaining payments.
♦ Extend the swap by blending it with a new one (blend-and-extend).
♦ Assign the swap to another party that will continue to make and
receive payments under the original swap agreement until maturity.
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INTEREST RATE OPTIONS
Caps and Floors
Interest Rate Collar
Swaptions
Exchange-Traded Options
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Interest Rate Options
♦ One party pays to reduce or eliminate risk, while the
other party accepts the risk in exchange for option
premium.
Option premium paid increases the effective borrowing
cost, or decreases the effective return on assets, for
hedgers.
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Interest Rate Options
♦ Pricing of interest rate options depends on several
factors including term to expiry, strike rate, and
volatility of the reference interest rate.
♦ Purchased interest rate options can be costly if the
underlying rate is volatile.
If underlying rates move, but not enough to make the
option worth exercising, the option will expire worthless,
resulting in a potential loss through adverse market rates as
well as the cost of the option premium.
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Interest Rate Options
♦ Since the buyer has control over its exercise, an option
is useful for covering contingent risk, where the
anticipated need for a hedge may or may not occur.
♦ By avoiding the necessity of locking in an interest rate,
even for a short time period, options provide
protection against worst-case interest rate scenarios
and flexibility for best-case scenarios.
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Caps and Floors
♦ Caps are agreements between two parties, whereby one party (for
an upfront fee) agrees to compensate the other if a designated
interest rate (called the reference rate) exceeds a predetermined level.
♦ For a floor, the payment is made if the reference rate is below a
predetermined level.
♦ The party that benefits if the reference rate exceeds (cap) or falls
below (floor) a predetermined level is called the buyer, and the
party that must potentially make payments is called the seller.
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Caps and Floors: Illustration
A U.S. manufacturer borrows by rolling over short-term debt every quarter. Concerned
about rising rates, the companybbuys an interest rate cap to cover its $10 million
floating rate debt. The cap strike rate is 5.00 percent, the reset period is quarterly, and
the reference rate is the London Interbank Offered Rate (LIBOR).
♦ Rollover 1. At the first rollover and cap date, the average reference rate is 4.25
percent. The company will do nothing, since the reference rate is lower than the
cap rate. The company will borrow at the lower market rates, and the cap will
remain for subsequent rollover dates until its expiry.
♦ Rollover 2. At the second rollover and cap date, the rate has increased to 5.65
percent. The company will be reimbursed by its bank for the difference between
the cap strike rate and the reference rate. Assuming 91 days in the period, this
amount is calculated as $10,000,000 x (0.0565 – 0.0500) x 91/ 360 = $16,430.56.
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Interest Rate Collar
♦ It is a relatively low-cost interest rate risk management strategy
that uses derivatives to hedge an investor’s exposure to interest
rate fluctuations.
♦ An interest rate collar involves the simultaneous purchase of an
interest rate cap and sale of an interest rate floor on the same
index, for the same maturity, and notional principal amount.
♦ This uses interest rate options contracts to protect a borrower
against rising interest rates while also setting a floor on declining
interest rates.
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Swaptions
♦ A swaption, also known as a swap option, refers to an option
to enter into an interest rate swap or some other type of
swap.
♦ In exchange for an options premium, the buyer gains the
right but not the obligation to enter into a specified swap
agreement with the issuer on a specified future date.
♦ Swaptions are over-the-counter contracts and are not
standardized like equity options or futures contracts.
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Swaptions
Swaptions come in two main types:
♦ In a payer swaption, the purchaser has the right but not the
obligation to enter into a swap contract where they become
the fixed-rate payer and the floating-rate receiver.
♦ A receiver swaption is the opposite where the purchaser has
the option to enter into a swap contract where they will
receive the fixed rate and pay the floating rate.
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Swaptions
Swaptions style:
♦ Bermudan swaption: the purchaser is allowed to exercise the option
and enter into the specified swap on a predetermined set of specific
dates
♦ European swaption: the purchased is only allowed to exercise the
option and enter into the swap on the expiration date of the swaption
♦ American swaption: the purchaser can exercise the option and enter
into the swap on any day between the origination of the swap and the
expiration date.
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Exchange-Traded Options
♦ An exchange-traded option is a standardized derivative
contract to either buy (using a call option), or sell (using a put
option) a set quantity of a specific financial product on or
before a predetermined date for a predetermined price (strike
price)
♦ This type of options attract investors as this is traded on an
exchange that settles through a clearinghouse and is
guaranteed.
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END OF THIS MODULE.