Interest Rate Hedging 

Hedging is a means of reducing risk. Hedging involves coming to an agreement with another party who is prepared to take on the risk that you would otherwise bear. The other party may be willing to take on that risk because he would otherwise bear an opposing risk which may be “matched” with your risk; alternatively, the other party may be a spectator who is willing to bear the risk in return for the prospect of making profit. In the case of interest rates, a company with variable rate loans clearly faces the risk that the interest rate would increase in the future as a result of changing market conditions which cannot be predicted.

Many financial instruments have been introduced in recent years to help corporate treasurers hedge the risks of interest rate movements. These instruments include:

Forward rate interest agreements (FRAs)

Financial interest rate futures

Interest rate swaps

Interest rate options (for interest rate guarantees)

Interest rate swaps and options on interest rates (SWAPTIONS)

Hedging means taking action to reduce or cover an exposure: Hedging is the process of financial risk management. It has a cost which could be either a fee to a financial institution or a reduction in profit, but companies might well consider the costs to be justified by the reduction in financial risks that the hedging achieves The degree to which the exposure is covered is termed the “hedge efficiency”. A perfect hedge has a 100% hedge efficiency.

Forward rate interest agreements (FRAs)

These are agreements between a company and a bank about the interest rate on future borrowing or bank deposits. For example a company can enter into an FRA with a bank that fixes the rate of interest for borrowing at a certain time in the future. If the actual interest rate proves to be higher than the rate agreed, the bank pays the company the difference. If the actual interest rate is lower than the rate agreed, the company pays the bank the difference.

One limitation on FRAs is that they are usually only available on high principal amounts, for example £500,000 loans. They are also likely to be difficult to obtain for periods over one year.

An advantage of FRAs is that, for the period of the FRA at least, they protect the borrower from adverse market interest rate movements to levels above the rate negotiated for the FRA. With a normal variable rate loan (e.g linked to a bank’s base rate or to LIBOR) the borrower is exposed to the risk such as adverse market movements. On the other hand, the borrower would similarly not benefit from the effects of favourable market interest rate movements.

The interest rate which banks will be willing to set for FRA s will reflect their current expectations of interest rate movements. If it is expected that interest rates are going to rise during the term for which the FRA is being negotiated, the bank is likely to seek a higher fixed rate of interest than the variable rate of interest which is current at the time of negotiating the FRA.

Futures

Futures are a form of forward contracts, which give a fixed rate of security prices or exchange rates of interest rate at a future date. A future contract can be defined a standardized contract covering the sale of purchase at a future date of a set quantity of a commodity, financial instrument or cash.

Futures market exist for various commodities, including sugar, gold, silver, wool, coffee, and they serve the useful function of permitting suppliers and consumers to plan on the basis of known future prices.

The London international financial futures and options Exchange (LIFFE) allows investors and business enterprises to use financial futures to speculate or to hedge against risks of movement in:

1. Gilt prices
2. Interest rates
3. Foreign currency exchange rates
4. Share prices
5. Bond prices (such as Japanese, US and UK government bonds)

The purchaser of a futures contract must deposit a sum as collateral for the contract, known as margin, which might be in the form of a bank letter of credit, treasury bills or cash. Changes in the value of the contract must also be paid for daily by means of a “variation margin”.

Currency futures

Futures in a foreign exchange rate are contracts to buy or sell a quantity of a foreign currency at a future date, and so in this respect they are similar to forward exchange contracts. Unlike forward contracts however,

1. Futures can be reversed quite simply
2. They are for fixed amounts of currency (e.g £25000 for a future against the US dollar, swiss francs Sf125000 against the US dollar etc.)
3. They are traded on a formal exchange such as LIFFE in London
4. Traders in futures have to put up “margin money”- pay money “up front”- to the clearers of the exchange, to ensure that they meet their future obligations.

Traders in foreign exchange futures on LIFFE are therefore dealers in large sums of money (often banks) seeking a way of hedging against exchange rate risks. Currency futures contracts can be used in a similar way to the non-standardized forward exchange contract  to hedge exchange risks, although it may not be possible to match the total value of contracts entered into with the amount involved in an actual transaction.

Interest rate futures

Interest rate futures are similar in effect to FRAs except that the terms, the amounts and the periods are standardized. Interest rate futures contracts are frequently used by banks and other financial institutions as a means of hedging their portfolios; such institutions are often concerned with achieving an exact match with the underlying exposure. Many, but not all, interest rate contracts are settled for cash as the underlying instrument cannot be delivered.

Interest rate futures offer an attractive means of speculation for some investors, because there is no requirement that buyers and sellers should actually be lenders and borrowers (respectively) of the nominal amounts of the contracts. A relatively small investment can lead to substantial gains, or alternatively to substantial loses. The speculator is in effect “betting” on future rate options.

Options

Options are an agreement giving the right to buy or sell a specific quantity of stocks or shares at a known or determinable price within a stated period. Pure options are financial instruments such as share options which are created by exchanges rather than by companies.

There are two quite different types of options dealt with on the stock exchange. They are:

• Negotiated options
• Traded options

Negotiated options:

Negotiated options are arranged individually for the investor by his stockbroker. They may be for a number of shares or for other stocks (except gilts). In practice, negotiated options are for either 16 days or 3 months. 3 months is more common.

An investor may acquire any of the following negotiated options:

• Call options: where is entitled to acquire the shares at a stated price within the specified period
• Put options: Where he has the right to sell the shares at the stated price within the specified period.
• Double option: Also called a straddle. It is a two-way option. It gives the right to buy or sell (and costs about twice as much)

The price within an option is called striking price. An investor has to pay for the privilege of having an option. He also has to pay an amount of broker’s commission, which is assessed on the striking.

Traded options

As the name implies, they are traded on the floor of a stock exchange or futures exchange. Like in a negotiated option, a traded option trades at a stike price, a put or call option could be purchased on the exchanges. The main difference between a negotiated option and a traded option is that unlike negotiated options that are arranged for individually by a stock broker, traded options can be traded on securities marketplace by institutional investors, individual investors, traders and so on.

Recommended Reading

Oleg V. Bychuk., Hedging Market Exposures : Identifying and Managing Market Risks