Friday, November 28, 2008


Management Of Interest Rate Risk.

Matters To Be Discussed--
  • -Influences on Interest Rates;
  • -Methods of Hedging Interest rate risk;
  • -Illustrating the effect of interest rate risk management techniques such as Swaps,Forward rate agreements,Futures & options.

Interest Rate.
Business wish to reduce their exposure to risk in all its forms & much has been written on this topic, ranging from the identification of different elements of risk ( interest rate,foreign , political) through to this quantification ( portfolio theory & CAPM). There remain ,however ,large areas of uncertainty.
Interest rate risk deals with the possibility of loss arising from a change in the level of interest rates.
As both a borrower & an investor of funds a company is exposed to variations in the interest rate.For example ,if a medium-term loan is taken out at a rate of say 15% ( variable) & interest rates are falling ,the changing interest rates will work to the advantages of the company. Conversely if interest rates were rising , or if the loan was fixed-rate the change would be detrimental to the company.
One important aspect of the treasury function is management of debt in such a way as to reduce the company's exposure to risk resulting interest rate movements.

Term Structure Of Interest Rates.
One of the primary considerations in evaluating debt is the likely movement in interest rates. This will affect the relative costs of long & short-term debt, as well as increasing or decreasing the preference for fixed interest rates. In practice , long-term rates will normally be higher than short-term rates, owing to the additional risk borne by the lender. Hence an interest premium is required to attract investors to longer-term securities.
This effect may be magnified or reversed by investors expectations of future rates, an anticipated rate rise producing higher longer-term rates. This difference between long & short-term rates is known as term structure.
In the general terms ,an increasing term structure results from two factors:
  • Increased risk of longer debt
  • Anticipated genaral interest rate rate rises.
More details analysis is littled required , however, below are listed formal theories as to why interest rates increase with time.

  • Expectations Theory.
This is states that the forward interest rate is due solely to expections of interest rate movement.
If an indidual wishes to borrow for two years, to obvious possibilites present themselves,
- Borrow for two years at an agreed rate,
-Borrow for one year & refinance for the second year ( i.e. pay off the first loan by talking out a second).
In option (a) the interest paid on the loan will be based on the current interest rate & the forward rate for one year. In option (be) the individual will consider the current interest rate & the expected interest rate for year. Thus the choice between the options hinges on whether the forward rate for year two is higher or lower than the expected rate.
From the lenders point of view if the expected rate was higher they would only lend short , preferring to renegotiate at the end of one year & take advantage of the anticipated rate rise. A similar argument could be made if the expected rate was lower than the forward rate, Thus for long -& short - dated dent to coexist, expected future rates & forward rates must be equal. Thus the term structure of interest rates is due purely to investor expectations.
  • Liquidity Preference Theory.
The problem with the expectations theory is that it ignores risk- if the expected rate for year two is the same as the forward rate then & individual needing to borrow for two years would choose a two- year loan since this eliminates the uncertainty of the actual interest rate to be paid in year two. Thus ,borrowers will aim to borrow for the period for which they need funds. If lenders wish only to lend for one year there will be a shortage of long funds & an.

Excess of short funds. This will lead to a premium on forword rates -(i.e.-Lenders will get a bonus for lending for two years & borrowers will have to pay extra if they insist on a two year loan.
In this case the term structure of interest rates would again be upword sloping but now it would be due to the liquidity preference of lenders & borrowers.
  • Market Segmentation.
It has been argued that demand for capital funds in practice can be segmented , particularly on a time basis. Thus , for example- Companies tend to finance stocks with short-term funds & equipment with long term funds. This leads to different factors affecting long- & short - term rates & a lack of a clear trend in the yield curve , characterized by irregularities such as humps & dips.

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