Interest Rate Risk Management (2)

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1 Introduction

In the previous chapter we looked at the risk involved in fixed interest rate borrowing, and methods of dealing with this risk.

In this chapter we look at interest rate swaps which involve the choice between borrowing at fixed or floating rate interest. It is unlikely that this topic will be in the compulsory part of the paper, but it has been reasonably common in the choice section.

2 Fixed or floating?

The advantage of fixed rate borrowing is that once the loan has been taken out, the interest payments are then certain and there is no risk due to future movements in interest rates.

However, a company may prefer to borrow at floating rate for two reasons:

1. they think that interest rates are going to fall and thus borrowing at floating rate will enable them to get the benefit of the fall (although clearly there is still a risk that they are wrong and that interest rates will rise)

2. more importantly, if they are in a type of business whose income rises and falls as interest rates rise and fall then it makes good sense to borrow at floating rate so that their expense falls as their income falls.

3 Interest rate swaps

Whether a company chooses to borrow fixed or floating, some companies can borrow at better rates than other companies depending on their credit rating.

Because of this, it is potentially (but not always) possible for two companies to swap their borrowings in a way that saves money for both of them.

This is illustrated in the following examples: