Managing Interest Rate RiskChapter No.

Managing Interest Rate Risk

Treasures is responsible for managing risk arising from interest from interest and exchange rate movements.

Interest rate and exchange rate are volatile.

Interest rate risk entails possibility of loss arising from a change in level of interest.

Borrower confronts risk of rising interest rate, while the lender confronts risk of falling interest rate.

Term Structure of Interest Rate or Yield Curve

• In general, long term interest rate tend to be higher than short term rate due to additional risk arising from time period and inflation.

• Term structure shows a relationship between long and short term interest rates.

• Three possible shapes of term structure:

• (1) Upward sloping

• (2) Downward sloping

• (3) Flat.

• See graphs on next slide and compare.

Factors Affecting Term Structure

Increased risk of long term debt

Anticipated general rise in interest rate.

Economic Growth

Inflation

Money Supply

Government Budget

Foreign Flows of funds.

Management of IR Risk The traditional method of managing IR risk is governed by matching

principle and fixed rate borrowing.

Matching Principle is borrowing such that inflows match outflows, i.e. borrow long term for long term assets and short term for current assets.

Fixed rate borrowing eliminates uncertainty regarding the future cash outflows.

However, development in financial and capital markets have facilitated the growth of number of instruments to cope with IR risk.

These instruments include Interest Rate Swap, FRA’s, Interest Rate Futures, Interest Rate Options

Interest Rate Swaps

Definition: An agreement between two parties (known as counterparties) where one stream of future interest payments is exchanged for another based on a specified principal amount. Interest rate swaps often exchange a fixed payment for a floating payment that is linked to an interest rate (most often the LIBOR). A company will typically use interest rate swaps to limit or manage exposure to fluctuations in interest rates, or to obtain a marginally lower interest rate than it would have been able to get without the swap.

Suppose: Quality Co. is a highly rated firm that prefers to borrow at a variable interest rate.

Risky Co. is a low-rated firm that prefers to borrow at a fixed interest rate.

Assume that the rates these companies would pay for issuing either floating (variable) rate or fixed rate bonds are as follows:

Assume that Quality Co. negotiates with Risky Co. to provide variable rate payments at LIBOR ½ % in exchange for fixed rate payments of 9½ %.

Quality Co. benefits because the fixed rate payments it receives on the swap exceed the payments it owes to bondholders by ½ percent. Its variable rate payments to Risky Co. are the same as what it would have paid if it had issued variable rate bonds.

Risky Co. is receiving LIBOR ½ % on the swap, which is ½ % less than what it must pay on its variable rate bonds. Yet, it is making fixed rate payments of 9½%, which is 1 percent less than what it would have paid if it had issued fixed rate bonds. Overall, Risky Co. saves ½ percent per year of financing costs

Both Quality and Risky gain ½ % each from the swap arrangement.

Interest Rate Swaps cont….

Illustration of IR Swap