Understanding corporate finance: derivative contracts: interest rate risk
Managing interest rate risk
A company which borrows money may borrow at a floating rate of interest (the interest rate moves as market rates move), or it may borrow at a fixed rate by, for example, issuing a debt security with a fixed interest coupon.
For example, suppose that a company takes out a loan at a rate of interest equal to, say, LIBOR plus 0.1%, and suppose that LIBOR is 4.1% at the start of the loan. The rate is to be reset each quarter by reference to current 3-month LIBOR. Clearly the company runs the risk of increased funding costs if commercial interest rates rise. The company may want to ensure that its funding costs do not rise above a certain level, or it may want to pay in effect a fixed rate of interest.
Suppose on the other hand the company borrows at a fixed rate of 4.5% for two years. If LIBOR rises to 4.5% or above, it will be better off than if it had the floating rate loan. But if interest rates remain static or even fall, it risks being locked into borrowing at above market rates. It may want to hedge that possibility by entering into a derivative contract which will pay out if interest rates fall.
Equally, investors run the risk of reduced yields if interest rates fall and may also wish to hedge by using interest rate derivatives.
Interest rate derivatives fall into three main categories:
- Interest rate futures and forward rate agreements (CFM13290)
- Interest rate swaps (CFM13320)
- Option products (CFM13330)
A company’s decision about which derivative to use will depend on a number of factors, particularly the following:
- The commercial objective which it is seeking to achieve.
- The maturity of the borrowing or investment which it is seeking to hedge. Futures and forward rate agreements are mainly used to hedge short-term interest rate exposures. If the borrowing or the investment is for more than 2 or 3 years, the company is likely to use an option product or a swap to hedge. Swaps can be used to hedge very long-term interest rate exposures of 10 years or more.
- Whether the company wants to pay a premium - which may be substantial - for an option product that gives the company the chance to profit if interest rates move the right way as well as protecting it if they move in the opposite direction.
- The company’s creditworthiness. If the company uses a product that does not involve payment of an up-front premium, it will have to establish a line of credit, or provide collateral.
- The size of transaction involved. Banks will not normally enter into interest rate swaps involving relatively small amounts.