Interest Rate Risk Management.
CONTINUE FROM POST 24...
The traditional method of managing interest rate risk has been fixed -rate borrowing in the form of loans . If is simple , & companies know how much they will need each year to service the debt, However, it is not always possible to obtain a loan at the rates, or for the amounts required.
An enterprise may wish to take precautions against interest rates moving up or down in the future , or many wish to change the existing structure of its funding or deposits , for instance for a fixed rate of interest to a floating rate. With the devolopmentof the financial markets & , in particular , the financial futures markets , a number of instruments have arisen which allow the treasurer to hedge interest rate risk.
Interest Rate Swaps.
An interest rate swap is an exchange of interest rate commitments , serch that a fixed -rate.
Commitment is exchanged for a floating-rate commitment. The parties to a swap retain their obligations to the orginal lenders . Which means that the swap parties must accept counter - party risk.
Interest rate swaps are used for purposes other than obtaining a cheaper financing rate. They could , for example- be used to change future case flows or to enhance returns.
Interest rate swaps are off balance sheet items , as the principal amount of the contract is not paid , & it is just an agreement to swap future cash flows. However, the existece of the swap should be maintained in the notes to the financial statements. The interest payments & receipts should be accrued over the life of the swap on a straight-line basis. Financial institutions which actively trade swaps revalue their positions the current market value.
Forward Rate Agreements.
A forward rate agreement ( FRA) is an agreement whereby an enterprise can lock in an interest rate today for a period of time starting in the future. On the future date the two counter parts in the FRA settleup & , depending on which way rates go , one will pay an amount of money to the other representing the difference between the FRA rate & the actual rate.
Example---
Thomas plc has $ 1 m loan outstanding on which the interest rate is reset six months for the following six months. And the interest is payble at the end of that six month period.
The next six monthly reset period may now be just three months away , but the treasurer of Thomas plc thinks that interest rates are likely to rise between now & then. Current six month rates are 8% & the treasurer can get a rate of 8.1% for a six month FRA starting in three months time.
By transactions an FRA the treasurer can lock in a rate today of 8.1%. If interest rates rise as expected to say 9% Thomas plc has reduce its interest charge as it will pay the current 9% rate on its loan but will recive from the FRA counterpart the difference between 9% & 8.1%.
If however rates drop to 7% Thomas plc will still end up paying an effective rate of 8.1% because although the interest rate on the loan is lower , the company will pay the FRA counterpart the difference between 7% & 8.1%.
If rates are 9% in three months time,
$
Interest payable on the loan 9% x $1 m x 6/12------------------------------------------ 45000
Amount receivable on FRA (9%-8.1%)x$1 m x 6/12------------------------------------ (4500)
net amount ---------------------------------------------------------------------------40500
The 40500$ is the net amount payable , giving an effective rate of 8.1%, If rates are 7% in three months time
$
Interest payable on the loan 7% x $1m x6/12--------------------------------------------35000
Amount payable on FRA ( 8.1% - 7%) x $ 1m x 6/12--------------------------------------5500
net amount---------------------------------------------------------------------------40500
The $ 40500 is the net amount payble , again giving an effective rate of 8.1%.
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