Interest rate hedging is a series of techniques that investors can use to minimize the effects of changing interest rates

on their finances. These techniques apply to a variety of situations and needs, including those of bond buyers, corporate borrowers, stock investors and traders with more complex needs. Interest rate hedging can use a variety of instruments to protect investor wealth.

History
1. Investors have always had to worry about fluctuating interest rates. For most of history, they had two basic options: they could get a long-term, high fixed rate of interest by purchasing bonds, or they could get a short-term rate that fluctuated over time. While long-term debt had higher average returns, it also carried more risk, since a rise in interest rates could destroy its value. Short-term debt carried fewer risks, but more volatility in return. An investor could not count on any particular income from year to year. Interest rate hedging appeared to help manage this risk, by allowing companies and individuals to determine in advance how much fluctuation and how much loss they could tolerate.

Hedging for Borrowers

2. When borrowers hedge interest rates, their primary goal is to avoid a sudden spike in interest rate payments. A borrower might be willing to pay the prime rate plus 3 percent when the prime rate is at 2 percent, but this might be unprofitable if the prime rate rises to 5 percent. To avoid this eventuality, such a borrower could enter into a swap agreement with a bank, whereby he would pay the bank a fixed rate, and the bank would pay him a rate based on the prime rate, on an amount that approximated the value of their loan. When the prime rate went up, the loan costs would go up, but the swap would pay more. When the prime rate dropped, the swap would pay less, and the loan would cost less.

Hedging a Portfolio
3. The simplest way to hedge interest rate risk in a portfolio is to purchase short-term securities whose value will not fluctuate significantly given higher interest rates. Another technique is to hedge this risk by purchasing put options on long-term debt (especially even longer-term debt than the debt in the portfolio). These options will pay off if interest rates drop, and if they rise, the rise in the value of the bonds will pay for the costs of the put options.

Hedging Complicated Risks

4. If an investor owns a long-term bond that does not have any kind of derivatives (for example, a private bond issued by an obscure company), the only way to hedge interest rate risks is to bet directly on the rates. This can be done by selling short treasury securities with a similar maturity to that of the bond. If rates rise, the securities will drop in value in a way that compensates the bondholder.

This technique carries risks, though. If the hedging portfolio shows a loss, but the hedged asset is not considered collateral, the investor may be forced to liquidate.

Other Techniques
5. Many banks offer custom interest rate swaps for their clients. These swaps are designed to perfectly hedge the customer's unique interest rate risks. These can be sold to borrowers, bondholders, or even individuals who fit into both categories.

Read more: What Is Interest Rate Hedging? | eHow.com http://www.ehow.com/about_6575086_interest-rate-hedging_.html#ixzz12nCrdHAM

Hedging Interest Rate Risks

By Jordan Slovin, eHow Contributor updated: June 27, 2010

1. Protecting against interest rate risk is one of the primary responsibilities of a portfolio manager. Changing interest rates can have a huge impact on the value of portfolios that rely on fixedincome payments. The sensitivity of a portfolio s value to this change is called interest rate risk. People with such portfolios, like bond traders, bankers and pension fund managers, all need to make sure that they are protected, or hedged, from fluctuating rates. While they can also be used to speculate, the goal of most hedges are to stabilize income by providing revenues which offset any change in the value of the main portfolio.

Interest Rate Swaps

2. Consider the case of a bank receiving 6 percent interest on 30-year mortgages while paying 4 percent on deposits, earning a margin of 2 percent. If interest rates rise, the bank will need to raise the rate they pay on deposits or risk losing them to other banks. However, since they cannot also raise the rates on their established mortgages, the bank risks losing the profit margin. To hedge against rising interest rates, the bank can enter into an interest rate swap.

In this arrangement, the bank would agree to pay a fixed rate of 4 percent interest on the amount of their deposits to another party in exchange for that party paying the bank a variable rate of interest on the same amount. If interest rates rise, the additional interest owed to the bank's customers will in effect be paid by the counterparty, as their payments to the bank will rise. The bank continues to pay 4 percent on their deposits, and the 2 percent profit margin is maintained.

Interest Rate Futures

3. Rising interest rates are also a risk to managers of bond portfolios. As interest rates rise, the older bonds lose value because they pay less interest than the newer bonds. To hedge against these losses, bond holders need an investment which provides equal gains when interest rates go up. By selling interest rate futures based on the same bonds, they can create such an investment.

Suppose it is September, and you sell a December future on a bond in your portfolio. This means that in December you must deliver the agreed-upon bond to the buyer. The payment you received for the future is based on the interest rate in September, but you are not going to buy the bond until December when you have to make delivery. If interest rates rise before December, the price of the bond will fall, and you will pay less than you have received, making a profit. However, the same bond in your portfolio will lose value. If the hedge is calculated correctly, the profit from the future will cover the loss and insulate you from the change in interest rates.

Bond Immunization
4. Since futures only work for specific bonds, they are not appropriate for companies that have liabilities which are infinite. These companies can hedge against interest rate risk through bond immunization. Consider a pension fund which pays retirees a fixed amount and funds this liability through its own investments. It cannot simply purchase one bond to cover these payments, since they are ongoing while bonds have specific time periods.

Using a formula, however, the pension fund manager can calculate the duration, or sensitivity, of the payments to changes in interest rates, and construct a portfolio of bonds which combine to produce a similar duration. In this way, changes in the value of the payments will be matched

by changes in the value of the securities held by the pension fund. It should be noted that this is not a one-off solution, because durations themselves change and thus necessitate periodic rebalancing of the pension s portfolio.

Read more: Hedging Interest Rate Risks | eHow.com http://www.ehow.com/list_6671498_hedginginterest-rate-risks.html#ixzz12nDEg9G4

Ways to Hedge Interest Rate Risk

By Michael Wolfe, eHow Contributor updated: October 2, 2010 1. Many investors, particularly those who have taken out large loans, stand to lose a significant amount of money if the interest rate rises above a certain point. Similarly, lenders may stand to lose money if the interest rate drops precipitously. For this reasons, these investors may seek to protect themselves against steep rises or falls in interest rate by "hedging" this risk using a number of financial products.

Cap
2. Borrowers can provide themselves a form of insurance by purchasing a financial derivative called a "cap." A party selling a cap agrees to pay the interest on an adjustable-rate loan after the interest rate exceeds a certain percentage. For example, if a borrower purchased a cap at 5 percent and the interest rate rose to 7 percent, the seller of the cap would have to pay two points of interest on the loan.

Floor
3. A floor functions similarly to a cap. Usually purchased by lenders, the seller of a floor provides insurance to its buyer by agreeing to cover him if the interest rate on an adjustable-rate loan falls below a certain price. For example, if a lender purchased a floor at 3 percent and the interest rate dropped to 2 percent, the floor's seller would pay its buyer one point of interest on the loan.

Collar

4. A collar is a combination of a floor and a cap that hedges an investor's bet by insulating her from changes in the interest rate, either up or down. A lender using a cap will generally purchase a floor and sell a cap, while a borrower will sell a floor and purchase a cap. Collars are advantageous because they pay for themselves; however, in exchange, the investor limits the amount of his potential gains.

Swaps
5. A swap is a financial derivative in which one investor trades payments derived from interest on a loan for another investor's regular payments of cash. The interest rate payments are generally pegged to an index, while the cash payments are fixed. In this way, an investor can essentially sell profits from the interest rate to another investor, causing him to take on the risks of severe fluctuations. Swaps can also be structured so that one interest rate is traded for another.

Futures
6. Like futures contracts on a commodities exchange, interest rate futures can be purchased by investors seeking to hedge their risk to interest rates by locking in a future price on rates. Some futures are purchased directly, while others are sold only as options, giving the investor the option, but not the obligation, to purchase a hedge on the rate.

Read more: Ways to Hedge Interest Rate Risk | eHow.com http://www.ehow.com/list_7269486_wayshedge-interest-rate-risk.html#ixzz12nDWVhU3

How to Use a Forward Contract to Hedge the Interest Rate Risk

By Tom McNulty, eHow Contributor updated: November 11, 2009

Interest rate risk to a borrower is the risk that rates will rise in the future. Many types of personal and corporate debt are floating, which means that the interest rate can be reset or move higher naturally if the rate is tied to an interest rate that goes up and down. Forward contracts can be used to hedge this type of risk.
Difficulty: Challenging

Instructions
1. 1

Determine what the mechanism is for the rate to move higher. Some rates can be reset only periodically based on movements in market rates such as the Prime rate, the Fed funds rate and LIBOR, which is the widely quoted London Interbank Offered Rate. Other interest rates can float all of the time, being tied directly to a rate that can move every day.
2. 2

Model the cash flows. Make a detailed spreadsheet of the debt, by month, using the actual dates involved in the schedule of interest and principal payments. If at all possible, build a forward curve of the interest rate that is used to calculate the interest expense. Then, run sensitivities on that forward curve to evaluate the magnitude of the forward exposure.
3. 3

Determine which type of forward contract best fits this stream of future interest cash flows. There are several commonly used instruments that can hedge forward interest rate exposure. The most direct is to lend the exact same amount of money that has been borrowed, at the exact same interest rate. This way, the interest expense earned will offset the interest expense paid. Forward contracts can be used to swap the floating interest expense with fixed future interest expense cash flows, thereby locking in a set rate in the present. Interest rate swaps are very common and represent a series of separate forward contracts that are timed to match the risk. This highlights the importance of making the detailed cash flow model outlined in Step 2.
4. 4

Identify counterparty and negotiate the deal. Banks make money by doing deals in the forward interest rate markets and it will not be difficult to locate one that is willing to be a counterparty to one of the types of trades described in Step 3. There will, however, be fees involved in dealing with a bank, so it is important to factor those fees into the cash flow model of the debt and its hedge.
5. 5

Manage the credit risk. The hedge will serve no purpose if the counterparty involved goes bankrupt and cannot pay its side of the deal. Look at the credit rating of the counterparty, and consider using a credit default swap to add protection against default. Such a swap would pay in the event of a default by the counterparty, but as in the case of all insurance, there will be a cost to entering the protective contract.

Read more: How to Use a Forward Contract to Hedge the Interest Rate Risk | eHow.com http://www.ehow.com/how_5630880_use-hedge-interest-rate-risk.html#ixzz12nDpMrX7

interest Rate Hedging Strategies

By Christopher Faille, eHow Contributor updated: September 11, 2010

1. Interest rate derivatives can display a bewildering variety. If you owe money at floating rates of interest, you want protection against the costs that a sudden spike in those rates would impose. You might achieve this by buying or selling one or more of a variety of instruments that increase in value as interest rates rise, thus hedging your interest rate exposure.

Interest Rate Futures

2. Perhaps the most direct interest rate hedge is the sale (or the purchase) of an interest rate future. If you are concerned about the prospect of a rise in interest rates, you'll presumably be the seller in such a contract. If interest rates rise thereafter, the buyer will pay you an amount equal to the benefit received from rates higher than those in the referenced underlying instrument.

Conversely, if interest rates decline during the period of the futures contract, you will owe the buyer an amount equal to the benefit lost. Since this is by hypothesis a hedge, your operational interests will benefit by the lower rates, so you will be willing and able to make that payment.

These futures have not caught on everywhere that they have been tried. The Economic Times of

India observed, in March 2010, that the National Stock Exchange had failed in its efforts to boost volume in these futures. Big players such as mutual funds and insurance companies had stayed away from such instruments "because of poor volume and liquidity issues," a concern that became self-fulfilling.

Swap (Fixed for Floating)

3. Traders speak of the two "legs" of a swap---one fixed, one floating. Another approach is an interest rate swap. One party agrees to pay another at a fixed rate of interest on a defined (notional) principal sum. The counter-party agrees to pay at the floating rate of interest on that same sum. No principal is actually exchanged. The two payments are netted out, so the party with the floating obligation will pay when the market rate rises above the fixed rate, and vice versa. The floating leg will typically be fixed against a published index such as the London Interbank Offered Rate (LIBOR).

Constant Maturity Swap

4. Both swaps and interest rate futures are considered "plain-vanilla" interest rate derivatives. The flavors can get a good deal fancier. There are floating/floating interest rate swaps, in which each party is making a bet on the changes in the yield curve over time. For example, you might believe that the difference between the spread between interest rates on six-month and 10year instruments will narrow. If so, you can structure a swap/swap derivative with a counterparty who is effectively betting that spread will widen.

Or the swap curve itself can be the point of reference for another derivative. A Constant Maturity Swap works in the same way as an interest rate swap, except the floating leg is constantly set against the market swap rate rather than against LIBOR or a similar first-order index.

Read more: Interest Rate Hedging Strategies | eHow.com http://www.ehow.com/list_6983051_interest-rate-hedging-strategies.html#ixzz12nEKZRWP