Relevant to the following CISI qualifications: Risk in Financial Services, Derivatives, ICAWM
Risks arise from the way the value of an investment changes with the level of interest rates. This is most clearly seen in the value of fixed-rate investments such as bonds. If interest rates rise, the opportunity cost from holding the bond falls as it becomes more advantageous to switch to other investments.
Alternatively, a company with a loan at a variable rate of interest may want to adapt its payments to avoid the risk arising from a rise in interest rates. It may also want to aid its financial planning by creating a more even pattern of repayment.
A number of instruments exist to hedge against the risks posed by changing interest rates. For a company that decides to reduce its exposure to rising interest rates associated with variable rate funding there are two main types of derivative.
A cap will ensure that the company does not have to find more than a maximum agreed level of interest. The company will benefit if interest rate levels stay below that level. A cap is paid for up-front. A variation on this instrument is the cap and collar, whereby the company will pay the seller of the product if interest rates fall below an agreed level.
Swaps allow the company to exchange variable-rate payments for a guaranteed fixed rate. Swaps do not generally require any advance payment to the seller.
There are a huge variety of swap instruments, reflecting the international nature of the debt market. For instance, although there would be no advantage in swapping a fixed rate for another fixed rate within the same currency, as the outcome would be known, it may be desirable to swap fixed rates between two currencies. Every variable of currency, floating and fixed exchange rate can be swapped.
Vanilla Interest Rate Swap
A company enters into a vanilla interest rate swap with a bank to reduce the risk from fluctuations on a $10 million loan it has taken out on a floating rate. The bank agrees to a fixed rate of, for example, 6% over five years, while the floating rates are based on the six-monthly Libor (London Interbank Borrowing Rate) plus 2%. If the Libor is 4% at the start of the agreement, the amount payable is 6% in both cases, although any percentage could be agreed.
If the Libor rises to 6%, the amount payable every six months would be 8% of $10 million divided by two, or $400,000. The company’s agreement with the bank is for a rate of 6%, or a payment of $300,000 in this case. The company will receive the difference of $100,000 from the bank.
The amount of the loan does not change hands and the company may continue to make the variable payments. It will receive cash if interest rates rise, and pay the bank if they fall. The net effect on the company is the same as if it had taken out a fixed-rate loan. Although the obvious route would be for a company to take out a fixed-rate loan, initially this may not be available or it may be too expensive.
Moreover, because the amount of the swap is notional, it is not necessary for the company to match the whole amount of the loan or to ensure that its entire life is covered. There may well be occasions when risk managers expect interest rate rises over the short to medium term. Continuing with a swap arrangement after the rises have peaked could wipe out initial gains.
- A swap is flexible, allowing a company to adjust its maturity, payment frequency, and principal to suit its ongoing financial arrangements.
- Interest rates can be managed independently of financing arrangements.
- There is no requirement for a payment up-front.
- The arrangement locks the company into a fixed rate that may not be advantageous.
- Early termination may incur a cost.
- There is a slight additional risk of failure from involving an additional financial institution in the swap arrangement.
This article was originally published on Tadawul Academy’s website: