Chapter-14 Interest Rate Risk
Interest Rate Risk
➢ Interest rate risk refers to the risk of an adverse movement in interest rates
and thus a reduction in the company’s net cash flow. The movement of
interest rates causes the risk.
➢ An organisation with Interest Rate Sensitive Assets/ Interest Rate Sensitive
Liabilities will face interest rate risk.
➢ Fear of rising interest rates- Fear of a Borrower
➢ Fear of falling interest rates- Fear of a Depositor
Gap Exposure
The degree in which a firm is exposed to interest rate risk can be identified
through gap analysis. This uses the principle of grouping together assets and
liabilities that are affected by interest rate changes according to their maturity
dates. There are two different types of gaps may occur in the following way:
➢ Negative gap
➢ Positive gap
Negative gap: It occurs when interest-sensitive liabilities maturing at a certain
time are greater than interest-sensitive assets maturing at the same time. This
result in a net exposure if interest rates rise by the time of maturity.
Positive gap: It occurs when the amount of interest-sensitive assets maturing in
a certain period exceeds the amount of interest-sensitive liabilities maturing at
the same time. In situation, the firm will lose out if interest rates fall by maturity.
If interest rate sensitive assets are equal No Gap
to interest rate sensitive liabilities
If interest rate sensitive assets are greater Positive Gap Net Depositor
than interest rate sensitive liabilities
If interest rate sensitive assets are lesser Negative Gap Net Borrower
than interest rate sensitive liabilities
Yield Curve
The yield curve is an analysis of the relationship between the yields on debt with
different periods to maturity. A yield curve can have any shape and can fluctuate
up and down for different maturities. There are three main types of yield curve
shapes are:
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➢ Normal yield curve- Longer maturity bonds have a higher yield compared
with short-term bonds due to the risks associated with time. This is a
positively sloping/upward sloping graph. As the time period increases, the
interest rate also increases.
➢ Inverted yield curve- The short-term yields are higher than the long-term
yields which can be a sign of upcoming recession. This is a negatively
sloping/downward sloping graph. As the time period increases, the
interest rate decreases.
➢ Flat yield curve- The short and long-term yields are very close to each
other, which is also a predictor of an economic transition. This is a flat line
graph. As the time period increases, the interest rate remains constant.
Liquidity Preference Theory
Investors have a natural preference for more liquid investments. They will need
to be compensated if they are deprived of cash for a longer period. Hence with
an increasing time period, a higher rate of interest is expected by the depositor
to compensate for their loss of liquidity over longer period of time.
Expectations Theory
The normal upward sloping yield curve reflects the expectation that inflation
levels and therefore interest rates will increase in the future. This theory states
that the shape of the yield curve varies according to investor’s expectations of
future interest rates. A curve that rises steeply from left to right indicates that
rates of interest are expected to rise in the future.
Market Segmentation Theory
The market can be segmented into two different types based on the time period
which is short-term and long-term. The demand and supply for both these
markets are different and they influence their respective market interest rates.
Investors are assumed to be risk averse and to invest in segments of the market
that match their liability commitments. The supply and demand forces in various
segments of the market in part influence the shape of the yield curve.
The significant of the yield curve
Financial managers should inspect the current shape of the yield curve when
deciding on the term of borrowings or deposits since the curve encapsulates the
market’s expectations of future movements in interest rates. For example, a
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normal upward sloping yield curve suggests that interest rates will rise in the
future. The manager may therefore:
➢ Wish to avoid borrowing long-term on variable rates, since the interest
charge may increase considerably over the term of the loan.
➢ Choose short-term variable rate borrowing or long-term fixed rate in stead
Hedging Interest Rate Risk
1. Forward rate agreements (FRAs)
The aim of an FRA is to:
➢ Lock the company into a target interest rate
➢ Hedge both adverse and favourable interest rate movements
➢ When the open market is favourable, we make a payment to the FRA
counterparty and it is called compensation paid
➢ When the open market is unfavourable, we receive a payment from the
FRA counterparty, and it is called compensation received.
The company enters into a normal loan but independently organises a forward
rate agreement with a bank:
➢ To hedge in relation to a loan, the company would buy the FRA from the
bank
➢ Interest is paid on the loan in the normal way
➢ If the interest is greater than the agreed forward rate, the bank pays the
difference to the company
➢ If the interest is less than the agreed forward rate, the company pays the
difference to the bank
2. Interest Rate Guarantees (IRGs)
An IRG is an option on an FRA. It allows the company a period of time during
which it has the option to take on an FRA at a set price.
➢ Favourable open market- Lapse the IRG
➢ Unfavourable open market- Exercise the IRG
➢ A premium will be paid to the IRG counterparty for bearing the risk of only
losses and no gains
Decision rules:
➢ If there is an adverse movement → Exercise the option to protect
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➢ It there is a favourable movement → Allow the option to lapse
IRGs are more expensive than the FRAs, as one has to pay for the flexibility to be
able to take advantage of a favourable movement.
If the company treasure believes that interest rates will arise:
➢ They will use an FRA, as it is the cheaper way to hedge against the
potential adverse movement.
If the treasurer is unsure which way interest will move:
➢ They may be willing to use the more expensive IRG to be able to benefit
from a potential fall in interest rates.
3. Interest Rate Futures
Interest rate futures work in much the same way as currency futures. The result
of a future is to:
➢ Lock the company into the effective interest rate
➢ Hedge both adverse and favourable interest rate movements.
Initial position Counter position
Borrower Sell futures Counter Buy
Depositor Buy futures Counter Sell
The gain or loss on the futures contracts may not exactly offset the cash effect
of the change in interest rates, i.e., hedge may be imperfect. This is known as
basic risk.
4. Interest Rate Options-
➢ An interest rate option is an option contract on interest rate futures.
➢ Borrowers go for Put Options- Right to Sell
➢ Depositors go for Call Options- Right to Buy
➢ Premium payment will be made upfront for the options by the holder of
the option.
5. Interest Rate Caps, Floors and Collars-
Interest rate caps- It is where an option is used to set a maximum interest rate.
If the actual interest rate is lower, the option is allowed to lapse.
Interest rate floor- It is where an option is used to set a minimum interest rate.
If the actual interest rate is higher, the option is allowed to lapse.
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Interest rate collar- It is where options are used to set both a maximum and
minimum rate. To an options contract, there are two parties- Holder and Writer
of an option.
➢ Usually, a holder pays a premium to the writer
➢ Holder of one type of option also becomes the writer of another option in
an interest rate collar
➢ This strategy causes a lower net cost to the holder of the option
➢ Premium will not be the same, as usually the call option premium will be
higher than the put option premium
6. Swaps
➢ An interest rate swap is an agreement whereby the parties agree to swap
a floating stream of interest payments for a fixed stream of interest
payments and vice versa.
➢ There is an exchange of interest but no exchange of principal. The liability
of the loans also will not be transferred.
➢ For swap to occur, the period and principal must be the same for both the
loans.
Other practical ways to manage risk
1. Cash Flow Matching
➢ Every future cash inflow must be balanced with an offsetting cash outflow
on the same day and every future cash outflow must be balanced with an
offsetting cash inflow on the same date for a portfolio to be considered
cash matched.
➢ Largely impractical means of eliminating interest rate risk
2. Asset and Liability Management
➢ If interest rates are established for liabilities for durations that are
different from those for offsetting assets, issues can develop. Companies
try to match the duration of their assets and liabilities in order to prevent
this.
3. Interest Rate Smoothing
➢ Having a mix of floating interest rates and fixed interest rates loans in the
total portfolio of business.
➢ If interest rates increase, then only variable portion of portfolio is attached
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