Most businesses are exposed to interest rate risks from their operating cash flows, their financing and their investments. Businesses with variable interest rate investments face the possibility of lower income when rates fall, while organizations with debt tied to changeable interest rates will have higher borrowing costs when interest rates rise. The objective is to use the various instruments to protect the company's financial statements from earning's volatility. The typical instruments used to manage interest rate risk include interest rate forwards, futures, swaps and options.
Interest Rate Forwards
A forward contract allows its buyer to fix today the future price of an asset, such as an interest-linked security. The buyer has to pay the agreed price on a settlement date, regardless of how the interest rate has moved. The seller is also required to deliver the asset on the settlement date, whatever the asset's price in the spot market. There is generally no up-front fee or margin on such contracts and nothing is paid before the settlement date. Interest rate forwards are typically cash-settled.
Forward Rate Agreements (FRA) are the most popular form of interest rate forwards contract, in which two parties agree that a certain interest rate will apply to a principal during a specified period. The notional principal amounts are agreed, but they are never exchanged. On the settlement date, if the actual rate is different from the agreed rate in the contract settlement, then one party pays the other a cash amount to cover the difference. The majority of FRAs are based on Eurodollar rates (typically LIBOR). Companies use FRAs to lock in the interest rate today, e.g. for future working capital financing scheduled in the future.
Interest Rate Futures
Interest rate futures are contracts based on an underlying asset whose price is dependent solely on the level of interest rates. The most popular short-term interest contracts are treasury bill and Eurodollar contracts which are typically traded on an exchange. They enable companies to hedge a one-period rate change. Most short-term contracts are cash-settled, while some long-term futures contracts involve settlement using long-term bonds. The market for these contracts is very competitive and has fairly narrow spreads.
Interest Rate Swaps
Interest rate swaps are flexible hedging instruments used by corporate treasurers for asset/liquidity management to extend or reduce the average maturity or exposure of an open interest position. The most common interest rate swap is the fixed-floating swap, which is the exchange of a fixed interest rate cash flow for a floating interest rate cash flow or vice versa, with both interest rates in the same currency, often called a 'vanilla rate swap'. If both interest rates are floating, then the exchange of cash flows is called a 'basis rate swap.'
Interest Rate Options
Interest rate options are an option-type derivatives where the payoff depends on the level of interest rates. There are three types: caps, floors and collars which all help to protect the user from unwanted interest rate fluctuations.
Rate Caps ensure that the borrower of a floating-rate loan pays no more than the predetermined maximum rate even if interest rates rise above this ceiling rate. If rates fall, then the borrower does not have to exercise the option and can enjoy the benefits of the lower rates. The price of this insurance is the premium paid for the cap.
Interest Rate Floors ensure that the owner of a floating-rate asset receive a minimum rate even if interest rates fall below a pre-determined floor level. If rates fall below this level, the floating-rate asset is protected by a put option on interest rates. If interest rates rise, the company is not obligated to exercise the put option and can just enjoy the higher income. The cost of this insurance is the premium paid for the interest rate floor.
Interest Rate Collars are a combination of interest rate cap and interest rate floor. A company that buys an interest rate cap and sells an interest rate floor is effectively locking in a range for borrowing costs. A collar has zero costs when the income received from selling the floor matches the premium paid for the cap. Costless collars are popular hedging vehicles providing some interest rate protection at zero cost.
Hedging and Managing Interest Rate Exposure
The first task for companies in managing interest rate exposure is to quantify the level interest exposure, and the second task is to stress-test their financing/investment portfolio to understand what it means if rates increase by 25 basis points (bps) or by 50 bps. Only then the corporate treasury department can implement a hedging programme to mimimize earnings interest volatility.
Interest Rate Risk Management Systems and Services
There are many systems and services to help the corporate treasurer minimise their earnings volatility which also minimise accounting risk and compliance risk.