Interest Rate Risk Management

Interest Rate Risk Management reduces a business’s exposure to fluctuations in interest rate movements. This is an important risk to consider for all borrowing enterprises, however can be of particular relevance to those businesses with a large debt or those with interest as a large percentage of their total expenses. Interest rates can be hedged using a number of different derivative products or by taking on a “Fixed” Loan product. Some of the hedging products available include:

– An interest rate Swap. This where the borrower “swaps” a fixed rate in the market for their floating rate. This is essentially fixing an interest rate.

– An interest rate Cap. This is where derivatives are used to structure a maximum interest rate you will pay on your loan while still being able to take advantage of downward movements in interest rates. This type of hedge will usually incur a premium up front (buying the privilege of the cap).

– An interest rate Collar (also known as a range rate hedge). This type of hedge provides a maximum interest rate a borrower will pay, similar to a Cap, however also has an interest rate “floor”. If interest rates fall below the floor, the borrower continues to pay the interest rate at the floor rate. This is a way in which an interest rate Cap can be structured to avoid paying an upfront premium.

– An interest rate Swaption is when the borrower has an option to enter into an Interest Rate Swap at a specified rate on a specified date in the future. There is no obligation to enter into the Swap if rates are below the specified rate.

– A forward start. This is where one of the derivative products mentioned above is agreed to start at a future date. This can be useful when wanting to hedge interest rates prior to the start of the loan term (ie when refinancing or for an extended settlement).