INTEREST RATE

RISK MANAGEMENT
INTERNATIONAL FINANCIAL MANAGEMENT
PART 4
 CONTENTS
➔ Term Structure of Interest Rates
➔ Interest Rate Risk
➔ Credit Risk
➔ Gap Exposure
➔ Basis Risk
➔ Internal Hedging
➔ Forwards Rate Agreements
➔ FX Options and FX Swaps
Interest Rates
Interest rates are the 'cost' of borrowing and lending money. These rates serve dual
roles: they reflect the state of the economy and also help regulate it through the
actions of central banks, which determine the base interest rates within an economy.
When large corporations need to borrow funds, they often turn to financial markets,
issuing what are known as debt securities, or more commonly, bonds. These bonds
symbolize a promise: the issuer will repay the borrowed amount plus some interest to
the bondholder.
Multinational companies often have multiple bond issues, distinguished by their
maturity dates and the currency used. These companies can also take loans directly
from commercial banks, typically choosing from among several large banks to secure
the most favorable interest rate available.
There is a trade-off between risk and return. Investors in riskier bonds (or banks that
give riskier loans) expect to be compensated for the additional risk with a higher rate.

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Term Structure of Interest Rates
The term structure of interest rates, commonly known as the yield curve, illustrates
the relationship between interest rates and the maturity of government bonds.

Simply put, it's a graph where the y-axis represents the yield to maturity, and the x-axis
shows the maturity of the bonds.

Generally, assets with longer maturities offer higher interest rates. However, there are
often exceptions. Interestingly, the yield curve can morph into various shapes, each
telling its own economic story:

Normal Yield Curve Flat Yield Curve Inverted Yield Curve

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The Yield Curve
A normal or upward-sloping yield curve indicates yields on longer-term bonds may
continue to rise, aligning with periods of economic expansion.
A flat yield curve can stem from either a normal or an inverted yield curve, reflects
transitioning economic conditions.
An inverted or downward-sloping yield curve suggests yields on longer-term bonds
may continue to fall, corresponding to periods of economic recession.
Interpretation:
● Expectations theory: forward rates are equal to expected future spot rates. Yield
curve slopes upward (downward) if interest rates expected to increase (decrease).
● Liquidity preference theory: interest rates are uncertain. Forward rate equals the
expected future spot rate plus liquidity premia.
● Segmented markets theory: interest rates are a function of the supply and
demand for bonds of the corresponding maturity.
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Interest Rate Risk: The Basics
Interest rate risk reflects how profit and cash flows might shift due to fluctuations in
interest rates. It's vital for organizations to predict how these monetary shifts,
whether rises or falls in rates, might influence their profits and cash flows,
subsequently determining whether mitigative actions are necessary.

It’s key to note that bond prices and interest rates have an inverse relationship.

Furthermore, bond prices exhibit convexity, meaning:

● When yields rise, prices don’t fall to the same degree, and vice versa.
● Long-term bond prices are more sensitive to rate changes than short-term ones.
● High-coupon bond prices are less sensitive to rate shifts than low-coupon ones.

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Sources of Interest Rate Risk
The general level of interest rates can fluctuate over time, affecting all fixed-income
assets in the market. Thus, bonds with similar characteristics may necessitate differing
returns in various periods due to these shifts in interest rate levels.

Inflation risk is another factor to consider, as most debt securities expose investors to
it. The stipulated interest payments and final principal amounts from these securities
are nominal and do not adjust with inflation, except in the case of floating-rate bonds,
which do provide partial protection by adjusting the coupon rate. When companies
issue these, they are accepting this inflation risk.

Liquidity risk pertains to the potential difficulty of selling a bond before its maturity
without conceding a significant market value discount. Bonds with infrequent trading
often embody high liquidity risk. Hence, companies issuing relatively illiquid bonds
(either in smaller amounts or in a limited number of issues) typically should offer a
higher yield to counterbalance this lack of liquidity.

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Fixed and Floating Interest Rate Debt
A company holding a substantial amount of fixed interest rate debt commits to set
interest payments, typically over an extended period. If interest rates sharply
decrease, this company may lose a competitive edge compared to those using
floating-rate borrowing, since the latter's interest costs and capital costs would
decrease.
A prevalent form of interest rate risk for companies is the volatility in cash flows,
especially when there's a high proportion of floating interest rate debt, which can
fluctuate with broader market conditions.
It's possible for some interest rate risks within a firm to offset each other, particularly
when the entity has both assets and liabilities sensitive to interest rate fluctuations.
For example, if interest rates increase, a company might pay more interest on loans
and other liabilities, but this could be offset by higher interest earned on assets, such
as money market deposits.
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Credit Risk
Credit risk, sometimes referred to as default risk, is the risk of loss if the borrower, or
bond issuer, fails to make full and timely payments of interest and/or principal.

Debt represents a legal obligation, but the company (borrower) may face financial
hardship and consequently not have the money available to make the promised
interest and/ or principal payments.

It is important to note that credit risk can affect borrowers even when the company
does not actually default on its payments.

For example, if market participants suspect that a particular bond issuer will not be
able to make its promised bond payments, the probability of future default will
increase and the investors will require higher yield on newly-issued bonds.

If the default risk increases, the banks will also raise interest rates for the company in
order to extend the existing credit or lend additional funds.

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Credit Rating and Credit Spreads
Investors may be able to assess the
credit risk of a bond by reviewing its
credit rating.
Independent credit rating agencies
assess the credit quality of particular
bonds and assign them ratings based
on the creditworthiness of the issuer.
Bonds of some developed countries
are considered very safe securities
that carry minimal default risk.
Relative to these government bonds,
yields on other bonds are typically
higher. Investors commonly refer to
this difference as the risky bonds’
credit spread.
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Gap Exposure
Gap analysis helps determine a firm's exposure to interest rate risk by aligning assets
and liabilities sensitive to interest rate changes according to their maturity dates,
revealing two possible 'gaps':

● A negative gap emerges when a firm has more interest-sensitive liabilities than
assets maturing at a particular time. The difference indicates the net exposure,
and if interest rates increase by the maturity date, the company is at risk.
● A positive gap exists if maturing interest-sensitive assets outnumber liabilities at
a given time, posing a risk to the company should interest rates decline by the
maturity date.

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Basis Risk
While it might seem that a company, with size-matched assets and liabilities and both
receiving and paying interest, would be immune to interest rate exposure, disparities
in the underlying rate bases can introduce risk.

For instance, one rate might be tied to LIBOR (London Interbank Offered Rate), a
benchmark for wholesale money market lending between London banks, while
another could be linked to SONIA (Sterling Overnight Index Average), a benchmark for
overnight unsecured transactions in the Sterling market.

Given that it's improbable for these two floating rates to move perfectly in sync — due
to their differing nature and basis — disparities in their movements, magnitude, or
timing can present a company with interest rate exposure, even when assets and
liabilities seem matched.

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Internal Hedging
Matching is where liabilities and assets with a common interest rate are matched.

For example, Subsidiary A invests in the money market at LIBOR and Subsidiary B is
borrows through the same market at LIBOR. If LIBOR increases, Subsidiary A's
borrowing cost increases and Subsidiary B's returns increase. The interest rates on the
assets and liabilities are therefore matched.

This method is most widely used by financial institutions such as banks and insurance
companies, who find it easier to match the magnitudes and characteristics of their
assets and liabilities.

Smoothing is where a company keeps a balance between its fixed rate and floating rate
borrowing. A rise in interest rates will make the floating rate loan more expensive but
this will be compensated for by the less expensive fixed rate loan. The company may
however incur increased transaction and arrangement costs.

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Forward Rate Agreements
Over-the-counter (OTC) traded contracts for forward rates:

● The buyer agrees to pay a fixed rate on a notional amount over a set period.
● The seller commits to pay a referenced floating rate (e.g. LIBOR) at maturity.
● Principal amounts are not exchanged, only interest payments calculated on a
notional amount.
● Future interest rates can be locked in.

Forward rate agreements hedge risk by fixing the interest rate on future borrowing.

A company can enter into a FRA with a bank that fixes the rate of interest for
borrowing at a certain time in the future.

If the actual interest rate proves to be higher than the rate agreed, the bank pays the
company the difference. If the actual interest rate is lower than the rate agreed, the
company pays the bank the difference.

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Forward Rate Agreements
Forward Rate Agreements (FRAs) are typically noted as “X × Y”, where X and Y are
months, and the term "×" is read as “by”.

Understanding this, let’s explore a “3 × 9” FRA, pronounced as “3 by 9”. The '3'

indicates that the FRA commences in three months, while the difference between the
3 and 9 (which is six) implies the underlying duration.

So, the payoff of this FRA is determined by the six-month LIBOR (or another pertinent
interest rate benchmark) starting in three months.

This “3 × 9” notation is a market standard, signaling an FRA beginning in three months

and spanning six months. Banks, when setting interest rates for FRAs, will align them
with their current anticipations of interest rate fluctuations, potentially seeking a
higher fixed rate if a rise in interest rates is anticipated during the FRA's term.

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FRA Valuation
FRA Result Notional Amount x (Reference Rate* + Fixed Uplift – FRA Rate) x
Receipt / Payment (+/-) (Number of Days of the Loan** / 360)

Payment on Underlying Notional Amount x (Reference Rate + Fixed Uplift) x

Loan (Number of Days of the Loan / 360)

Net Payment Payment on Underlying Loan - FRA Result

(Net Payment / Notional Amount) x

Effective Interest Rate
(360 / Number of Days of the Loan)

* The reference rate could be LIBOR, SONIA, EUROBIR, ESTR or any other reference
interest rate.
** Use the 30/360 day count convention.
*** Note that the FRA and loan need not be with the same bank.
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Interest Rate Futures
Interest rate futures can be used to hedge against interest rate changes between the
current date and the date at which the interest rate on the lending or borrowing is set.

Borrowers sell futures now (and buy them back later) to hedge against interest rate
increases and lenders buy futures now (and sell them back later) to hedge against
interest rate decreases.

Interest rate futures are similar in effect to FRAs, except that the terms, amounts and
periods are standardized. Futures allow companies to hedge large exposures of cash
with a relatively small initial employment of cash (initial performance margin).

On ICE (Intercontinental Exchange), futures contracts based on SONIA, SOFR, Euribor

and Saron are available with delivery months of March, June, September, and
December for up to 10 years in the future. Interest rate futures contracts are cash
settled.

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Interest Rate Options
An interest rate option conveys the right, but not the obligation, to deal at an agreed
interest rate (strike rate) at a future maturity date. On the expiration date of the
option, the buyer must decide whether or not to exercise the right.

An interest rate call option gives the buyer the right, without an obligation, to benefit
off an increase in interest rates (to pay a fixed rate, lower than the current market
rate).

An interest rate put option gives the buyer the right, without an obligation, to benefit
off a decrease in interest rates (to receive a fixed rate, higher than the current market
rate).

Tailor-made 'over-the-counter' interest rate options can be purchased from major

banks, with specific values, periods of maturity, denominated currencies and rates of
agreed interest. The cost of the option is the premium. Interest rate options offer more
flexibility than and are usually more expensive than FRAs.
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Interest Rate Option Valuation
From the viewpoint of an option buyer (hedger), for every interest rate option, there is a
fixed cost also called a premium:

Premium = Premium Rate x (Number of Days / 360) x Notional Amount

Interest rate call option (caplet) payoff at the expiration date is determined by the
following formula:

MAX(Market rate – Option rate, 0) x (Number of Days / 360) x Notional Amount

Interest rate put option (floorlet) payoff at the expiration date is determined by the
following formula:

MAX(Option rate – Market rate, 0) x (Number of Days / 360) x Notional Amount

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Caps, Floors and Collars
An interest rate cap, comprising a series of call options (or "caplets"), establishes a
maximum limit on interest rates for a floating-rate loan, providing a hedge against
rising interest rates.
An interest rate floor, made up of put options (or "floorlets"), sets a minimum interest
rate, offering protection against declining rates. Both instruments function as
insurance, safeguarding against adverse movements in interest rates.
A collar strategy involves simultaneously purchasing an interest rate cap and selling
an interest rate floor. This approach effectively confines the interest rate to a specified
range, thereby limiting exposure to fluctuations. While the collar strategy curtails
costs due to the premium received from selling the floor offsetting the cost of buying
the cap, it also sacrifices the potential benefits of favorable interest rate movements
beyond the established boundaries.
If the premiums for the purchased cap and sold floor are equal, it creates a zero-cost
collar, mitigating direct outlay but still forsaking potential gains outside the range.
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Practice Problems: Interest Rate Hedging
1. Assume today is 31.12.2021. Oknoplast Poland, a leading Polish glass manufacturer,
has entered into a preliminary contract to borrow PLN 10 million on 31.03.2022 for six
months at an interest rate of WIBOR (Warsaw Interbank Offered Rate)+0.5% p.a. The
loan will be used to invest in a new manufacturing facility. The current 6-month
WIBOR stands at 3%. In three months it is expected to be either 2.5% or 3.5%.
PKO Bank Polski has offered two possibilities to hedge the interest rate risk:
i) A Forward Rate Agreement (FRA) at 3.5% p.a.
ii) A call option (caplet) at 3% p.a. plus a premium of 0.2% of the borrowed amount.
State what type of FRA is required.
Calculate the result of the FRA in each scenario (if the FRA benchmark rate moves to
either 2.5% or 3.5%).
Calculate the result of the option hedge in each scenario.
Discuss whether the company should hedge and which opportunity it should choose.
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Interest Rate Swaps
An interest rate swap is an agreement where two parties exchange cash flows based
on interest rates at specified future times according to certain specified rules.

Interest rate swaps can act as a means of switching from paying one type of interest to
another, raising less expensive loans and securing better deposit rates. The major
players in the swaps market are banks and other financial institutions, national and
local governments.

Interest rate swaps involve two parties agreeing to exchange interest payments with
each other over an agreed period. In the simplest form, party A agrees to pay the
interest on party B's loan, while party B reciprocates by paying the interest on A's loan.

The two parties usually swap interest which has different characteristics – one party
switches from paying floating rate interest to fixed interest and vice versa. This type of
swap is known as a 'plain vanilla' or generic swap.

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Interest Rate Swaps in Real Life
Example: An agreement where Apple receives 6-month LIBOR and pays Tesla a fixed
rate of 5% per annum every 6 months for 3 years on a principal of $100 million.

5%
APPLE TESLA
LIBOR

In practice, it is unlikely that two companies will contact a financial institution at the
same time to take opposite positions in exactly the same swap.

Many financial institutions act as market makers for swaps.

Market makers post quotes (bid and ask) for rates known as swap rates.

Thus the swap rate is the fixed rate that the market maker is willing to pay/receive in
exchange for LIBOR.
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Swap Rate and FRAs
The cash flows of a swap for the receiver of the fixed rate can be replicated by using a
series of FRAs.

Therefore, the swap can be thought of as a combination of multiple FRAs with

successively longer maturity dates. One way to compute the swap rate is by taking the
present value average of the FRA rates.

An important assumption is that unless the yield curve is flat, there will be different
fixed rates on the FRAs expiring on the swap's payment dates.

The swap fixed rate, therefore, can be seen as a complicated average of the fixed rates
on a series of FRAs encompassing the same time to maturity, but some of these rates
can be either above or below the swap rate.
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Practice Problems: Interest Rate Swap
2. Cornwall Plc, a UK company, wishes to convert its 3% fixed rate loan of £10 million
into a floating rate loan, because the financial manager has a strong view that interest
rates will sharply decrease over the next few years.
Bancroft Plc, a long-time banking partner of the company, offers to swap the fixed
semi-annual payments for floating semi-annual payments based on 6M SONIA + 2%.
The current value of SONIA is 1.5%.

A. Calculate the first interest payments that the two parties will exchange.

One year from now the forecast of the financial manager has proven wrong and the
value of 6M SONIA is 3%.

B. Calculate the next interest payments that the two parties will exchange.

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THANK YOU!