CH10 – Interest rate

F3 – Financial Strategy
risk management

Chapter 10
Interest rate risk management

Chapter learning objectives:

Lead Component Indicative syllabus content

C.3 Recommend ways (a) Recommend ways • Responses to economic transaction and
of managing financial to manage economic translation risks
risks. and political risks
(b) Discuss currency • Operations and features of swaps, forward
risk instruments contracts, money market hedges, futures
(c) Discuss interest and options
rate risk instruments • Techniques for combining options in order
to achieve specific risk profile such as caps,
collars and floors
Internal hedging techniques

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1. Interest rates

The lending rate is always higher than disposing rate as bank always wants to make a
“profit”.

LIBOR, LIBID and Basis Points:

London Inter Bank Offer Rate (LIBOR):

• Major banks use LIBOR to borrow wholesale short-term funds from another bank in the
London money markets.

• Different LIBOR rates prevail for different durations of borrowing (typically from
overnight to one year).

• Variable rate loans are linked to LIBOR.

• A loan at LIBOR + 2%, where LIBOR is 4.5% means that the consumer will be paying
interest of 6.5% on the loan.

• LIBOR rates are calculated each day by British Bankers Association and known as BBA
LIBORS.

• These are used as benchmark rates for some financial instruments, such as short-term
interest rate futures.

• LIBOR is important because London is the world’s lending money market centre.
EURIBOR:

• Banks in the eurozone produce an alternative benchmark rate of interest for the EURO
known as EURIBOR.

• This is similar in concept to euro LIBOR.

• The only difference is that the average rate is calculated daily from data submitted by a
completely different panel of banks.

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Basis Points:

• Floating rate loans are linked to LIBOR.

• A company may take loans at 1.25% above LIBOR.

• In the language of financial markets, 1% = 100 basis points.

• Therefore, a loan at 1.25% above LIBOR might be called a loan at LIBOR plus 125
basis points.

• If it pays interest every six months, the interest payable at the end of each period will
be set with reference to the LIBOR rate at the beginning of the period.

LIBID:

• Stands for the London Interbank Bid Rate.

• Less important than LIBOR.

• The rate of interest that a top-rated London bank could obtain on a short-term wholesale
deposits with another bank in the London money markets.

• LIBID is always LOWER than LIBOR.

2. Interest rate risk and its management

Interest rate risk:

• Risk that the interest rate might change in value.

• Linked to the risk to cash flow and its competitiveness.

• May be upside or downside risk.

• May occur between the point when company identifies the need to borrow or invest and
the actual date when it enters into the transaction.
Note: Compared to exchange rates, interest rates are LESS volatile, but changes in them
can be SUBSTANTIAL.

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Interest rate management techniques

3. Internal hedging methods

“Restructuring the company’s assets and liabilities in a way that minimises interest rate
exposure”

Smoothing:

• Trying to maintain a certain balance between its fixed rate and floating rate borrowing.

• A portfolio of fixed and floating rate debts thus provides a natural hedge against
changes in interest rates.
• Less exposure to the adverse effects of each, but there will also be less exposure to
favourable interest rate movements.
Matching:

• Matching the company’s assets and liabilities to have a common interest rate.

• For example, loans and investments both have floating rates.

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Netting:

• A company aggregates all positions, both assets and liabilities.

• This is done to determine its net exposure.

4. External hedging
Fixing Insurance Exchange traded
OTC Instruments
instruments instruments instruments

• Lock a • Allow some • Bespoke. • Ready-made.

company into a upside • Tailored • Standardised.
particular flexibility in the products that fit
interest rate interest rate. the company's
providing • The company need exactly.
certainty as to can benefit
cash flow. from favourable
movements but
is also
protected from
adverse
movements

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5. Forward Rate Agreements (FRAs):

• A forward contract on an interest rate for a future short –term loan or deposit.
• Can be used to fix the interest rate on a loan or deposit starting at a date in the future.
• A contract relating to the level of a short-term interest rate, such as three-month
LIBOR or six-month LIBOR.
• FRAs are normally for amounts greater than one million.

Features and operations:

• An important feature of an FRA is that the agreement is independent of the loan or
deposit itself
• It pertains to the rate of interest on a notional amount of principal (loan or deposit)
starting at a future date.
• It does not replace taking out the loan (deposit) but, rather, the combination of the
loan (deposit) and the FRA results in a fixed effective interest rate.
Settlement of FRAs:
The buyer and seller must settle the contract when the FRA reaches its settlement date.
Make a cash payment to the seller if fixed rate in the agreement is HIGHER than the
reference rate LIBOR.

• Payment is for the amount, by which the FRA rate exceeds the reference rate (LIBOR).
Make a cash payment to the buyer, if the fixed rate in the agreement is lower than the
reference rate (LIBOR).

• Payment is for the amount by which the FRA rate is less than the reference rate.
Setting up a hedge:
Hedging is achieved by the combination of an FRA with a normal loan or deposit.
Borrowing:

• A firm will borrow the required sum on the target date and will contract at the market
interest rate on that date.
• The firm will have bought a matching FRA from a bank or other market maker so that
it will receive compensation if the rate rises.
Depositing (when concerned about a fall in interest rates):

• The firm will deposit the required sum on the target date and will thus contract at the
market interest rate on that date.
• The firm will have sold a matching FRA to a bank or other market maker so that it will
receive compensation if rates fall.

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Pricing for an FRA:

• Priced according to the current bank base rate and future expectations of its
movements.

• The bank will try to predict the interest rate at the date of inception of the borrowing and
over its duration and add on a profit margin.

• The bank will expect to make a profit for the risk they are taking in lending money to the
company; therefore, the FRA will be priced at the same amount above the base rate as
for a borrower.

Test your understanding 1 on FRAs

It is 31st of December. Barilla company needs a GBP 20 million 6 month fixed rate loan from 1 March,
which it needs to hedge using a forward rate agreement (FRA). The relevant FRA rate is 7% on 31st
of December.
What will the net payment on the loan be if interest rates rose to 10% by March?

6. Interest rate guarantees (IRGs):

• Options on FRAs so that the treasurer has the choice whether to exercise it or not.

• These are referred to as interest rate options or interest rates caps/floors.

Features and operations:

• Over-the-counter instruments arranged directly with the bank.

• Have a maximum maturity of one year.

• A company would only exercise the option to protect against an adverse interest rate
movement.

• IRGs are more expensive than FRAs, an one has to pay for the flexibility to be able to
take the advantage of a favourable movement.

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7. Interest rate futures (IRFs)

• Similar to forward rate agreements in principle.

• Give a commitment to an interest rate for a set period.

• Are tradeable contracts.

• Operate for set periods of three months and terminate in March, June, September and
December.

• As with currency futures, the future position will normally be closed out for cash and
the gain or loss will be used to offset changes in the interest rate.

Features and operations:

The future operates through the customer making a commitment to effectively deposit or
borrow a fixed amount of capital at a fixed interest rate. The notional sterling deposit/loan
on LIFFE (London Future Exchange) is £500,000.
Pricing:
The future is priced by deducting the interest rate from 100.

• If the interest rate is 5%, the future will be priced at 95.00.

• This is because if the interest rate increases, the value of the future will fall and vice
versa.

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Gains and losses:

Gains and losses on STIRs are calculated by reference to the interest rate at the date of
close-out. The difference between the future price at inception and close will be the gain or
loss.

Limitations of IRFs:

• Contract sizes and a standard contract length (3 months).

• Margins, deposits payable at the start of the hedge.

• Speculators – who dominate the markets.

FRAs vs STIRs:

• Both are binding forward contracts on a short-term basis.

• Both are contracts on a notional amount of principal.

• Both are cash settled at the start of the notional interest period.

• FRAs have the advantage that they can be tailored to a company’s exact requirements,
in terms of amount of principle, length of notional interest period and settlement date.

• Futures are more flexible with regards to settlement because a position can be closed
out quickly and easily at any time up to the settlement date of the contract.

• The difference between the two in terms of effective interest rate is unlikely to be large.
Hedging with bond futures:

• Used to hedge the risk of a change in the price of bonds over the next few months.

• Bond futures fall in value when interest rates go up.

• For a bond investor, the required hedge is to sell future bonds.

• If the interest rates go up, both the bonds and the bond futures will fall in value.

• The future positions can be closed by buying futures at a lower price than the original
sales price to open the position.
• The gain on the future positions should match the loss in the value of the bonds
themselves.

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8. Exchange traded interest rate options

This option gives its buyer the right to buy or sell an interest rate future at a specified future
date at a fixed exercise rate.
Because they are an option, as opposed to a commitment, they require the option holder to
pay the writer of the option a premium.

Characteristics of an option:
• They fix the interest on a notional amount of capital.

• They are for a given interest period starting on or before a date in the future.

• Standard size of contracts i.e. £500,000 or £1,000,000 etc.

• Duration of the contract i.e. 3-month contract.

• Maturity dates, end of March, June, September and December.

Call option: gives the holder the right to buy a futures contract.
Put option: gives the holder the right to sell a futures contract.

Collars:
• Premiums can be reduced by using collars.

• Simultaneously buying a put and selling a call option creates a collar.

• Hence, a cap and floor are created, but the premium is saved.

• The premium saved comes at the expense of giving up the benefits of any interest rate
falls below the floor value.

• A collar is a way of achieving some flexibility at a lower cost than a straight option.

• Under a collar arrangement, the company limits its ability to take advantage of a
favourable movement. It buys a cap (a put option) as normal, but also sells a floor (a
call option) on the same futures contract with a different exercise price.

9. Swaps
Swap: a contract to exchange payments of some sort in the future.
There is no exchange of principal.

Interest rate swap

• An agreement whereby two parties agree to swap a floating stream of interest payments
for a fixed stream of interest payments and vice versa.
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• The most common form of interest rate hedge used by companies

• Banks act as swap counterparties.
• There is a large and liquid market in swaps in major currencies and banks will quote
bid/offer rates against a reference rate such as 6 month LIBOR or 12 month LIBOR.

Example:

Advantages Disadvantages

A way of managing fixed and floating rate debt Finding a swap partner can be difficult.
profiles.
Used to take advantage of the expected Need to assure the credit-worthiness of your
increases or decreases in interest rates. swap partner.
Used to hedge against variations in the interest Interest rates may change in the future, and the
on floating rate debt. company may get locked into an unfavourable
rate.
Used to obtain the cheaper finance.

Cross currency swaps

• It allows a company to swap a currency it currently holds for a different currency for a
fixed period, and then swap back at the same rate at the end of the period.
• The company's counterparty in a cross currency swap would generally be a bank.
• The swap of interest rates could be ‘fixed for fixed’, 'floating for floating' or ‘fixed for
floating’.
• The company entering the cross currency swap will end up with the currency it needs
and also the type of interest rate it prefers (fixed or floating).
• It involves:
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o An exchange of principals in different currencies, which are swapped back at the

original spot rate.
o An exchange of interest rates – the timing of these depends on the individual
contract.

Advantages Disadvantages

A useful tool for changing the currency profile Finding a swap partner can be difficult.
of debt.
It may help reduce interest costs where debt Need to assure the credit-worthiness of your
can be raised more easily or at a competitive swap partner.
rate in a second currency.
It may also be used as part of a broader Interest rates may change in the future, and the
strategy for managing currency risk. company may get locked into an unfavourable
rate.

Solution to Test Your Understanding 1 on FRAs

At 10% the company will pay 10% x GBP 20 m x 6/12 = GBP 1m
The FRA receipt will be GBP 20m x (10%-7%) x 6/12 = GBP 300,000
Net Payment GBP 1,000,000 – GBP 300,000 = GBP 700,000
Or the company will essentially pay 7% x GBP 20m x 0.5 year = GBP 700,000

10. Chapter summary

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