Focusing on economic forecasts that predict how interest rates will fluctuate or studying the sophisticated products that banks offer are essential parts of a treasurer’s duties. Nonetheless, the management of interest rate risks should always be grounded in a comprehensive understanding of the underlying element – business foreign exchange.
What Exactly is Interest Rate Risk?
As FX Forwards lock in a rate and are calculated off the spot rate at the time (plus the relevant interest rate parity and the length of the contract), the client is effectively deprived of negotiating more advantageous terms. Interest rate risk is thus essentially referred to as exchange rate risk.
Consequently, if the interest rates involved are shifted during the term of the contract, the client is not eligible for any advantageous changes in rates. Likewise, if the exchange rate shifts materially, the client will have no opportunity to benefit from favourable changes in the underlying spot price. Treasury departments should therefore assess these risks prior to using business FX in their currency hedging.
What is Interest Rate Risk Hedging?
By far, hedging is one of the most popular financial management techniques available to mitigate interest rate risks. Consider the following factors before making any hedging decision:
- Those who are risk-averse commonly use hedging techniques to protect their jobs and reduce the financial risk exposure to the business.
- As risk hedges involve derivatives, business management may lack the skills in accounting and taxation.
- Using derivatives to hedge financial risks has different costs and still may not guarantee complete elimination of the financial risks.
In that regard, businesses have two hedging options to mitigate the risk of rising interest rates: internal and external methods. Following are the various interest rate hedging techniques associated with each internal and external method:
Internal Hedging Techniques
Smoothing Technique: As part of internal hedging, smoothing techniques are used to manage interest rate risk. By establishing a balance between variable and fixed interest rate loans, the business can manage its debt portfolio internally. Variable interest rate loans, for instance, are short-term facilities, and fixed interest rate loans are generally long-term. Meanwhile, balanced fixed and variable interest rate debts allow for stable long-term and short-term outcomes.
Matching Technique: As part of the internal hedging strategy, matching is another strategy used to manage interest rate risk. Interest is paid on liabilities and earned on investments. In interest rate hedging, interest earned and paid are compared for matching purposes. Likewise, if the lender stipulated a fixed or variable interest rate, both borrowing and investing could be matched.
Netting Method: Lastly, the netting method is used for internal hedging. A business can use it to determine the net benefits or costs involved with both borrowing and investing. If the business decides to hold investment interest rates higher than debt interest rates, the interest earned may be used to increase the profits.
As with any business, it would seem difficult to adapt to any one of the methods. However, with a good finance mix, both in terms of assets and liabilities and income and earnings that are influenced by interest rates, businesses can benefit from a low-risk interest rate exposure.
External Interest Rate Hedging
Forward Rate Agreements: Due to a change in interest rates for large amounts of borrowings, businesses may be vulnerable to losses. Among the strategies used for neutralizing interest rate risk, forward rate agreements are one such strategy. In a FRA, the business and the bank agree to decide a future interest rate contractually.
Interest Rate Futures: Under external interest rate hedging techniques, interest rate futures are one of the strategies for managing external interest rate risk. The interest rate or any futures in agreement terms are similar to the FRA, except that futures offer borrowers a greater degree of flexibility. Among the forms of Interest rate guaranteed IRGs, futures focus on future commitments to borrow or lend a designated amount on a future date.
Interest Rate Options: Another interest rate risk management strategy involves interest rate options. An Interest Option gives the borrower the option of buying or selling a contract at a future date. A borrower who anticipates a change in interest rates enters into an option contract and reserves the right to exercise the option or allow it to expire at the closing date.
Interest rate risks can be hedged in various ways, with more appropriate techniques available for different scenarios. For instance, one company may qualify for a short-term loan depending on leverage and solvency but may need a long-term facility to fund operations, and vice versa. However, the bottom line is that the right techniques need to be adopted to ensure efficient interest rate risk management.