Section G of the Financial Management Study Guide specifies the following relating to the management of interest rate risk: Show (a) Discuss and apply traditional and basic methods of interest rate risk management, including: (i) matching and smoothing (ii) asset and liability management (iii) forward rate agreements (b) Identify the main types of interest rate derivatives used to hedge interest rate risk and explain how they are used in hedging. (No numerical questions will be set on this topic) The cause of interest rate riskRisk arises for businesses when they do not know what is going to happen in the future, so obviously there is risk attached to many business decisions and activities. Interest rate risk arises when businesses do not know: (i) how much interest they might have to pay on borrowings, either already made or planned, or (ii) how much interest they might earn on deposits, either already made or planned. If the business does not know its future interest payments or earnings, then it cannot complete a cash flow forecast accurately. It will have less confidence in its project appraisal decisions because changes in interest rates may alter the weighted average cost of capital and the outcome of net present value calculations. There is, of course, always a risk that if a business had committed itself to variable rate borrowings when interest rates were low, a rise in interest rates might not be sustainable by the business and then liquidation becomes a possibility. Note carefully that the primary aim of interest rate risk management (and indeed foreign currency risk management) is not to guarantee a business the best possible outcome, such as the lowest interest rate it would ever have to pay. The primary aim is to limit the uncertainty for the business so that it can plan with greater confidence. Traditional and basic approachesMatching and smoothingWhen taking out a loan or depositing money, businesses will often have a choice of variable or fixed rates of interest. Variable rates are sometimes known as floating rates and they are usually set with reference to a benchmark such as SONIA, the Sterling Overnight Index Average. For example, variable rate might be set at SONIA +3%. If fixed rates are available then there is no risk from interest rate increases: a $2m loan at a fixed interest rate of 5% per year will cost $100,000 per year. Although a fixed interest loan would protect a business from interest rates increases, it will not allow the business to benefit from interest rates decreases and a business could find itself locked into high interest costs when interest rates are falling and thereby losing competitive advantage. Similarly if a fixed rate deposit were made a business could be locked into disappointing returns. Smoothing In this simple approach to interest rate risk management the loans or deposits are simply divided so that some are fixed rate and some are variable rate. Looking at borrowings, if interest rates rise, only the variable rate loans will cost more and this will have less impact than if all borrowings had been at variable rate. Deposits can be similarly smoothed. There is no particular science about this. The business would look at what it could afford, its assessment of interest rate movements and divide its loans or deposits as it thought best. Matching This approach requires a business to have both assets and liabilities with the same kind of interest rate. The closer the two amounts the better. For example, let’s say that the deposit rate of interest is SONIA + 1% and the borrowing rate is SONIA + 4%, and that $500,000 is deposited and $520,000 borrowed. Assume that SONIA is currently 3%. Currently: Annual interest paid = $520,000 x (3 + 4)/100 = $36,400 Annual interest received = $500,000 x (3 + 1)/100 = $20,000 Net cost = $16,400 Now assume that SONIA rises by 2% to 5%. New interest amounts: Annual interest paid = $520,000 x (5 + 4)/100 = $46,800 Annual interest received = $500,000 x (5 + 1)/100 = $30,000 Net cost = $16,800 The increase in interest paid has been almost exactly offset by the increase in interest received. The extra $400 relates to the mismatch of the borrowing and deposit of $20,000 x increase in SONIA of 2% = $20,000 x 2/100 = $400. Asset and liability managementThis relates to the periods or durations for which loans (liabilities) and deposits (assets) last. The issues raised are not confined to variable rate arrangements because a company can face difficulties where amounts subject to fixed interest rates or earnings mature at different times. Say, for example, that a company borrows using a ten-year mortgage on a new property at a fixed rate of 6% per year. The property is then let for five years at a rent that yields 8% per year. All is well for five years but then a new lease has to be arranged. If rental yields have fallen to 5% per year, the company will start to lose money. It would have been wiser to match the loan period to the lease period so that the company could benefit from lower interest rates – if they occur. Forward rate agreements (FRA)These arrangements effectively allow a business to borrow or deposit funds as though it had agreed a rate which will apply for a period of time. The period could, for example start in three months’ time and last for nine months after that. Such an FRA would be termed a 3 – 12 agreement because is starts in three months and ends after 12 months. Note that both parts of the timing definition start from the current time. The loans or deposits can be with one financial institution and the FRA can be with an entirely different one, but the net outcome should provide the business with a target, fixed rate of interest. This is achieved by compensating amounts either being paid to or received from the supplier of the FRA, depending on how interest rates have moved. Example: Nero Co’s cash flow forecast shows that it will have to borrow $2m from Goodfellow’s Bank in four months’ time for a period of three months. The company fears that by the time the loan is taken out, interest rates will have risen. The current interest rate is 5% and this is offered by Helpy Bank on the required FRA. Required (i) What kind of FRA is needed? (ii) What are the cash flows if the interest rate has risen to 6.5% when the loan is taken out? (iii) What are the cash flows if the interest rate has fallen to 4% when the loan is taken out? (i) The FRA needed would be a 4 – 7 FRA at 5% (ii) If the interest rate has risen to 6.5%: (iii) If the interest rate has fallen to 4%: Note: Interest rate derivativesThe interest rate derivatives that will be discussed are: (i) Interest rate futures
|