RISK MANAGEMENT -MAIN TECHNIQUES/INSTRUMENTS
Interest Rate Guarantee (IRG)/Option
- These provide a degree of flexibility which is not provided by certain other instruments. They protect one from adverse interest rate movements but also allow one to profit from favourable
- Interest Rate Cap – Borrower agrees with bank a ceiling to the interest rate on a loan. If the interest rate turns out to be higher the bank pays the difference to compensate. If the interest rate turns out to be lower than the agreed rate, the company benefits by borrowing at the lower market rate. The effect of the Cap is to ensure that the borrower pays no more than the agreed rate, no matter how high interest rates move.
Unlike certain other techniques the buyer of the Cap must pay a premium (price) up-front, when the agreement is set.
Future Rate Agreement (FRA)
- A Future Rate Agreement (sometimes called a Forward Rate Agreement) is an agreement between a bank and a customer made to-day (contract date), whereby:
The customer can secure an agreed interest rate (contract rate)
On an agreed amount of its borrowings (principal amount)
For an agreed duration (period)
Commencing on an agreed future date (settlement date)
- The FRA does not require any outlay of cash.
- The guaranteed interest rate is achieved by the exchange of an amount of money (settlement amount) between the parties.
- The FRA is ideal for:
Depositors seeking protection against a fall in interest rates, or
Borrowers who want to protect against a rise in interest rates.
FRA Example – Loan
On the 1st January a corporate treasurer realises that a loan of RWF10m. which had been borrowed on a six month rollover basis has one month to run to the next rollover. Currently, the loan is based upon an interbank rate of 10%. He reckons interest rates will rise significantly over the coming months and he wants to protect his current position. The six month FRA rate, for the period commencing one month hence is quoted at 11%. He decides to do an FRA for the period in question for RWF10m
Interest Rate Swap
- An Interest Rate Swap is a transaction in which two parties agree to exchange their respective fixed interest rate and floating rate borrowings at periodic intervals over a specified time period in order to reduce the cost of borrowing for both. This may be arranged to exploit different interest rates available in different markets or to change the profile of the company’s debt.
The Swap is based on a notional amount and does not involve any exchange of principal – each party will still pay on its primary debt but they settle the adjustment in the cash flows of interest rates between themselves. Interest payments are usually netted so that only one payment has to be made between the parties
The settlement figure will be adjusted every 6 months to reflect changes in the 6month INTERBANK rate. This will leave Company B with a fixed rate (11%) over the entire five year period and Company A with a floating rate.
- Conceptually, a swap is the same as a series of FRA’s but it allows corporations to hedge interest rate exposures for 10 years or longer.
- Swaps are easy to arrange, flexible (any size, maturity and can be reversed if required) and transaction costs are low.
- The swap does not have to be arranged with the same bank from whom the original borrowings have been arranged.
- There are many applications for, and variations of, an Interest Rate Swap. Swaps are useful from both a liability management as well as an asset management perspective. Companies that borrow on a fixed or floating rate basis can use a swap to alter the interest rate profile (i.e. from floating to fixed or vice versa). Asset managers that desire to alter the frequency at which their investments are re-priced can use the swap market for this purpose.
- In addition to assisting in the management of interest rate risk, swaps offer several other advantages including:
- Swaps can often reduce all-in financing costs or increase investment yields, relative to alternative sources and uses of funds.
- Once credit approval has been obtained, swaps can be executed in a matter of minutes. Documentation is standard, resulting in reduced administration.
- Swaps are typically off-balance sheet transactions.
- Swaps are customised transactions to meet the specific needs of the client, including notional principal amount, tenor, indices (fixed/floating), frequency of settlement etc.
- A liquid market exists making it easy to unwind transactions or close out transactions early should interest rate views change.
- Some of the reasons why a swap may be used are:
- Borrowing costs may end up lower than direct borrowing in the market.
- The company can change its debt profile, without involvement in further debt.
- Availability of finance markets that are not open to the company directly.
Note: An Interest Rate Swap is not a source or use of funds.
A swap is used to manage the interest rate risk associated with an underlying transaction.
Swaption (Option on Swap)
- Swaptions are hybrid derivative products that integrate the benefits of swaps and options.
- The buyer of a swaption has the right, but not the obligation, to enter an interest rate or currency swap during a limited period of time and at a specified rate.
- Swaptions require the payment of a premium, normally upfront.Financial Futures
- The Futures Market has long been a risk management tool in the commodities markets, used for forward buying/selling of everything from coffee beans to tin. Its advantages will be familiar to a manufacturer who relies on raw materials whose prices are susceptible to cyclical variances.
- A futures contract can be described as a binding agreement to buy/sell through an established Exchange, at a specified price, on a definite date, a standard quantity of a commodity of predetermined quality on fixed conditions of delivery.
- In the case of Financial Futures the commodity is currency or financial paper. They were first traded in the International Money Market in Chicago in 1972. In the U.K. the London International Financial Futures Exchange (LIFFE) opened in September 1982.
- Futures contracts are standardised – the size of each contract and the maturity dates are standard. They offer an alternative covering mechanism for currency and interest rate risk. Actual or anticipated risks in money or foreign exchange markets (cash markets) can be minimised by taking an equal and opposite position in the futures market. Any cash market loss resulting from adverse exchange or interest rate movements should be offset by profits on futures contracts (and vice versa).
- Although each futures deal is negotiated between the buying and selling parties, the actual financial transaction is conducted by the Exchange’s clearing house. By interposing itself between the two transacting parties it provides a guarantee against default.
- Note: No exchange of principal takes place.
To avoid the risk of default by holders of contracts a purchaser/seller of a futures contract must deposit an Initial Margin with the clearing house, effectively as security. This Initial Margin is very small relative to the size of the contract. As prices fluctuate each day the value of the outstanding contracts will change. If the price has moved in favour of the contract-holder, the surplus (called a variation margin) is added to the Margin Account and is available for distribution to the contract-holder. Similarly, if the price moves against the contract-holder he must cover any losses to ensure that at the close of every business day his total margin, net of losses, is equal to the Initial Margin. The Initial Margin is set at a level which is unlikely to be exceeded by losses arising from the price movement of any one day.