Monitoring interest rates and acting on changes in them is an important part of a treasurer’s role. Whether looking at the yield on excess cash invested or the interest rate on outstanding or new issue debt, treasurers need to be aware of the impact of interest rate changes on the balance sheet, P&L and the instruments and techniques available to mitigate the effects of those changes.
Herewith how interest rate risk can be problematic for several reasons. First, Companies with floating or variable rate debt outstanding are exposed to increases in interest rates, whereas companies with borrowing costs which are totally or partly fixed will be exposed to falls in interest rates. The reverse is true for companies with cash term deposits. Second, pension schemes that carry liability and investment risk for the sponsoring corporation have interest rate risk in that liabilities act in a similar way to bonds, rising in value as interest rates fall and vice versa. Lastly, although a nonfinancial firm will usually report its bonds on the issue in financial statements, at levels often substantially different to their face value, early redemptions must be done at the market value. This may be significantly different, as interest rates will change the value of fixed-rate debt.
The question now is, how can it be avoided? All of the issues above involve a decision to accept exposure either to a fixed interest rate or a floating rate. This decision can be taken at any time over the life of a debt or an investment and can be modified at any time. It is also possible to purchase instruments that cap interest rates at a maximum, floor them at a minimum or allow them to fluctuate within a pre-defined band. Deciding to fix, float or accept a defined range of possible interest rates is the definition of managing interest rate risk. Hedging a floating interest rate means deciding to fix all or part of the exposure. Hedging a fixed rate exposure means deciding to transform all or part of it into floating rate. The following lists the main instruments used for managing interest rate.
Natural hedging. It is basically creating interest rate exposures that are offset by elements of the company’s natural business cycle. In normal times, for example, construction firms enjoy a rise in business activity when interest rates fall, as investors build more when the cost of projects is lower. Conversely, some firms may benefit from high levels of economic activity that prompt a high-interest rate response by central banks.
Forward date. A FRA is a tool for fixing future interest rates (or unfixing them) over shorter periods, up to say one to two years. A 3v6 FRA allows a firm to fix the three-month Libor (or another reference) rate in three months’ time. It is dealt over the counter (with banks) and can be tailored to any (short-term) tenor.
Futures contracts. Futures have the same function as FRAs. Futures are exchange-traded, have fixed tenors, terms and conditions, and require complex margining. They are therefore less flexible than over-the-counter instruments.
Exchange-traded options contracts. Interest rate options, bond options, and options on fixed-income exchange traded funds are short-term instruments used to express views on whether rates will rise or fall. Exchange-traded options have the same drawbacks as exchange-traded interest rate futures contracts. Over-the-counter options, such as caps and floors are preferred by most corporates.
Cap. An option that caps the interest rate payable by a borrower over its life. Below the cap level, the interest rate payable is floating. Caps are dealt over the counter by banks. The commonest use is by borrowers who need to avoid covenant breaches that would be caused by sharp rises in rates and so purchase a cap to set the maximum rate they will have to pay over the life of a bond or loan.
Floor. An option that fixes the minimum interest rate receivable over its life. Floors are dealt over the counter by banks. Treasurers with cash invested might buy a floor that is lower than current interest rates to set a minimum return.
Collar. A collar combines the purchase of a cap and a floor. This sets a corridor of possible interest rates between a maximum and a minimum. A borrower would buy a cap and sell a floor, usually over the counter, thus creating a ‘collar,’ or corridor, of rates. Usually, the purchase and sale prices cancel each other out.
Interest rate swap. An interest rate swap changes the nature of a stream of interest payments from floating to fixed or vice versa. Swaps are dealt over the counter and the market is large and deep. Maturities of anything from one year to 30 years are available.
Swaption. A swaption is an instrument where the buyer of a swaption has the right to enter into an interest rate swap as either payer or receiver of the fixed rate at a particular rate, thus protecting the buyer against adverse movements in long-term rates while allowing him to benefit from favorable moves. Swaptions are usually only used by nonfinancial firms in relation to a specific event such as a bond issue or an M&A transaction that will require funding.