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
SONIA, the Sterling Overnight Index Average. For example, variable rate might
be set at SONIA +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 SONIA + 1% and the
borrowing rate is SONIA + 4%, and that $500,000 is deposited and $520,000
borrowed. Assume that SONIA 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 SONIA 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 SONIA 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
=
(32,500)
$2m x 6.5/100 x 3/12 =
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
=
(20,000)
$2m x 4/100 x 3/12 =
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:
1. You pay a premium to take out the protection. This is non-returnable
whether or not you make use of the protection.
2. If interest rates move in an unfavourable direction you can call on the
insurance.
3. 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.