Interest Rate Risk Management

1 Introduction

Interest rate risk arises when an entity does not know how much interest it will have to pay on its borrowings, or how much it will earn on its deposits — whether those borrowings and deposits already exist or are only planned.

The consequences run further than the interest line itself. An entity that cannot forecast its interest cost cannot complete a reliable cash flow forecast; changes in interest rates alter the weighted average cost of capital and therefore the outcome of a net present value appraisal; and an entity that committed itself to floating rate borrowing when rates were low may find a rise in rates more than it can carry.

2 Where interest rate risk comes from

The fourth and fifth of those are the ones examiners return to, because the exposure exists before any interest is payable at all. Chapter 8 works the illustration: a company that has decided on 1 June to borrow for six months from 1 September is exposed to rate movements over the three months in between, even though the loan itself will be at a fixed rate once drawn.

Every instrument in sections 4 to 8 is an answer to one or more of the rows above. Section 9 sets out how to choose between them.

3 Basic and internal approaches

Before any derivative is bought, three things can be done with the entity's own borrowings and deposits.

3.1 Smoothing

Borrowings, or deposits, are simply divided between fixed rate and floating rate. If rates then rise, only the floating part costs more, and the effect is smaller than it would have been had everything been floating. Deposits can be smoothed in the same way.

There is no science in it. The entity looks at what it can afford, forms a view of where rates are going, and splits the book accordingly. It is not a hedge; it is a way of not being wholly wrong.

3.2 Matching

Matching requires the entity to have both borrowed and deposited money, and works best when the two amounts are close. Because both move with the same benchmark, the movements largely cancel.

Suppose the deposit rate is BR + 1% and the borrowing rate BR + 4%, that $500,000 is on deposit and $520,000 borrowed, and that BR is currently 3%.

A two-point rise in the benchmark has changed the net cost by only $400 — and that $400 is entirely explained by the $20,000 by which the borrowing exceeds the deposit: $20,000 × 2% = $400. What is hedged is the matched $500,000; what is exposed is the mismatch.

3.3 Asset and liability management

Matching deals with amounts. Asset and liability management deals with periods — how long the borrowings last against how long the assets they fund produce income. The problem is not confined to floating rate arrangements: fixed rate money can mature at the wrong time just as easily.

Suppose an entity borrows on a ten-year mortgage secured on a new property at a fixed rate of 6% a year, and lets the property for five years at a rent yielding 8% a year. All is well for five years. Then a new lease has to be negotiated, and if rental yields have fallen to 5% the entity begins to lose money on a loan it cannot repay for another five years.

The answer was to match the period of the borrowing to the period of the lease, so that the two decisions come up for renewal together and the entity can take advantage of lower rates if they occur. The same idea appears in chapter 5 as the maturity dimension of the target debt profile, and the risk it manages is refinancing risk.

4 Forward rate agreements

A forward rate agreement (FRA) fixes the rate of interest on a borrowing or deposit that will be taken out at a future date, for a set period. The entity still borrows from whichever bank it chooses, at whatever rate is then available; the FRA provider — which may be a completely different institution — pays or receives the difference between the rate that turns out and the rate agreed, so that the two together give the entity the fixed rate it wanted.

FRAs are over-the-counter instruments: they are negotiated individually with a bank, for any amount and any period.

5 Interest rate futures

An interest rate future is a standardised, exchange-traded contract. Buying one creates the right to receive interest at a given rate; selling one creates the obligation to pay interest at a given rate.

5.1 Price, and why it moves the way it does

The reason is worth working through rather than memorising. Suppose a contract lets its holder receive interest at 5%, which is the current market rate. If market rates rise to 6%, a depositor can get 6% in the market and only 5% under the contract, so nobody will pay as much for it and the price falls. From the other side, a borrower who has to pay 6% in the market would rather pay 5% under the contract, so there are many willing sellers, and that too pushes the price down until buyers and sellers balance.

5.2 How futures are traded

• Contracts are for a standard amount and a standard period of three months. The examples in this chapter use a contract of $500,000; the actual size differs between currencies and exchanges.

• Only whole contracts can be dealt, so the number needed is:

Number of contracts = (Amount to be hedged ÷ Contract size) × (Period of the loan or deposit ÷ 3 months)

So covering a $3 million loan for six months needs $3m ÷ $0.5m × 6 ÷ 3 = 12 contracts. The second fraction is there because each contract only covers three months.

• A tick is the smallest movement in the price, 0.01 of a percentage point, and its value is the contract size × 0.01% × 3/12.

• An initial margin is paid when the position is opened, and further margin is called if it moves against the holder. The margin is not the cost of the hedge; it is a deposit against the position.

• Contracts trade on futures exchanges rather than being arranged individually with a bank.

5.3 Which way to deal

A futures hedge is two parallel transactions: the entity borrows or deposits in the market at whatever rate then applies, and takes a futures position designed so that the profit or loss on it offsets the movement in the interest.

If rates move the other way, the position still works — in reverse. A borrower who sold futures and then saw rates fall pays less interest but makes a loss on the futures; a depositor who bought futures and then saw rates rise earns more interest but loses on the futures. In both cases the combined outcome is stable, which is the object of the exercise.

5.4 Why a futures hedge is never perfect

• Basis risk. Futures prices do not move exactly in line with interest rates, so the gain on the futures does not precisely offset the movement in the interest.

• Contract size and dates. Only whole contracts of a standard size and a standard maturity can be dealt, so the hedge rarely fits the exposure exactly.

• Margin. The position has to be funded, and further margin may be called before the hedge matures.

An answer recommending a futures hedge should say all three.

6 Interest rate options

Interest rate options — also called interest rate guarantees — protect the entity against an adverse movement while leaving it free to benefit from a favourable one. They work like an insurance policy:

1. a premium is paid to take out the protection, and it is not returnable whether the protection is used or not;

2. if rates move unfavourably the entity exercises the option;

3. if rates move favourably the entity lets the option lapse and simply takes the better market rate.

The options are written on interest rate futures, so they give the right, but not the obligation, to buy or to sell a future at an agreed price on an agreed date. Contract sizes and periods are those of the underlying future (section 5.2), so the number of contracts is calculated in exactly the same way.

6.1 Using options when borrowing

With plain futures a borrower would sell now and buy later. With options it buys the right to sell a future at an agreed price — a put option. Suppose that price is 95.

6.2 Using options when depositing

With plain futures a depositor would buy now and sell later. With options it buys the right to buy a future at an agreed price — a call option, again say at 95.

7 Caps, floors and collars

The three named techniques for shaping the risk profile are built out of the options in section 6.

A collar is the first case in this chapter of selling an option rather than buying one, and it is worth being clear about what that costs. Selling a floor means someone else has the right to be paid if rates fall below the floor rate; if they do, the entity has to pay. So it has given up the benefit of a large fall in rates, and the premium it received for doing so is what makes the cap affordable.

8 Interest rate swaps

In an interest rate swap two parties agree to exchange interest payments with each other over an agreed period — typically one paying a fixed rate and the other a floating rate on the same notional amount. Neither party's own borrowing changes; what changes is who ends up bearing which kind of interest.

8.1 Why there is anything to gain

A swap only works if there is an advantage to both parties, and the advantage arises because lenders price the two parties differently in the fixed market and in the floating market. The difference between those two differences — the quality spread differential — is the total gain available, and it is what the parties divide between them.

8.2 A swap between two companies

Company A can borrow at a fixed rate of 8%, or at a floating rate of BR + 2%. Company B can borrow at a fixed rate of 9%, or at a floating rate of BR + 5%. A wants fixed and B wants floating.

The spreads differ by 2%, and that 2% is the gain available. Confirm it by totalling the two ways the money can be raised:

So each borrows the kind it does not want and they swap. Splitting the 2% equally, A should end at 8% − 1% = 7% fixed and B at BR + 5% − 1% = BR + 4%. The legs that achieve it are: A pays B 5% fixed, and B pays A BR.

The parties can divide the 2% however they negotiate; an equal split is the usual assumption where a question does not say otherwise. What matters is that each ends up better than it could have done alone — otherwise it would not sign.

8.3 A swap arranged through a bank

Two companies finding each other, trusting each other and having exactly complementary needs is difficult in practice. Swaps are therefore usually arranged with a bank, which takes the other side of both legs and keeps part of the saving.

Company A can borrow at a fixed rate of 10% or at BR + 1%, and prefers fixed. Company B can borrow at 9% fixed or at BR + 0.5%, and prefers floating. Note that B can borrow more cheaply than A in both markets; that does not prevent a swap, because what matters is the comparative difference — 1% in the fixed market against 0.5% in the floating market, so 0.5% is available.

The bank pays BR to Company A in exchange for 8.8% fixed, and accepts BR from Company B in exchange for paying it 8.6% fixed. The floating legs cancel inside the bank, which is left with 8.8% in and 8.6% out.

The three amounts add back to the 0.5% that was available: 0.2% to A, 0.1% to B and 0.2% to the bank. The bank is paid for solving the matchmaking problem and for carrying the credit risk on both legs.

8.4 A method that works on any swap question

8.5 What a swap does not do

• The principal is never exchanged. Only the interest flows are swapped, on a notional amount, and neither party's own loan agreement changes. (A currency swap is different: because the two legs are in different currencies the principal is exchanged at both ends — chapter 9, section 10.)

• It replaces interest rate risk with counterparty credit risk. If the other party fails, the entity is left with the borrowing it took out and none of the compensation it swapped for. Dealing through a bank moves that risk to the bank.

• It does not repay anything early. A swap changes the character of the interest, not the maturity of the debt, which is why it is the standard tool for adjusting the interest basis of a debt portfolio without refinancing it — chapter 5, section 5, on the target debt profile.

9 Choosing an instrument

10 Test your knowledge

Two quick checks before you move on: work through the flashcards to fix this chapter’s terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.