Comparative advantages and disadvantages to hedge interest rate risk

Abstract: All firms-domestic or multinational, small or large, leveraged or unleveraged- are sensitive to interest rate movements in one-way or another. They have some exposure to interest rate risk if they have any asset that earn interest or any on which interest is paid. Interest rate risk can be significant for companies with massive financial assets and liabilities unless it is properly managed or hedged. Interest rate options can be arranged to hedge a series of future interest periods or for a single interest period of up to one year, which is known as interest rate guarantee. Alternatively, the terms borrower's option and lender's options are used to describe single interest period interest rate options and interest rate caps and floors to describe a series of payments or receipts. This paper tries to discuss the alternative methods that are available to hedge interest rate risk on a short-term three months loan, and a three year long-term, both required in three months time. The initial section discusses hedging short-term risks using a forward rate agreement, short-term interest futures, and borrowers and lenders interest options; and their comparative advantages and disadvantages. Author: Chintha Sam Sundar, Faculty of College of Business and Economics, Asmara, Eritrea. samsundarchintha@gmail.com Introduction: Interest rate risk is the risk of incurring losses due to adverse movements in interest rates. Companies are exposed to interest rate risk when they are expecting some income or payment in the future and the amount of income or payment will depend on the interest rate at the time. Furthermore, companies are exposed to this risk when they have assets whose market value changes whenever market interest rate change (Cuthberson and Nitzsche, 2001; ACCA, 2007).

This paper tries to discuss the alternative methods that are available to hedge interest rate risk on a short-term three months loan, and a three year long-term, both required in three months time. The initial section discusses hedging short-term risks using a forward rate agreement, short-term interest futures, and borrowers and lenders interest options; and their comparative advantages and disadvantages. This is to be followed by a discussion of the alternative long-term interest rate risks hedging methods and their comparative advantages and disadvantages, and conclusion. Alternative Interest Rate Risk Hedging Methods There are several methods of hedging the interest rate risk. These include the use of: a) Forward rate agreement (FRAs) b) Interest rate futures c) Interest rate options (borrowers and lenders interest rate options, interest rates caps and floors options, and interest rate collars options) d) Interest rate swaps Forward rate agreement, short-term interest rate futures and borrowers and lenders interest rate options are used to hedge exposures to short term interest rate risk which are associated with borrowing or investing (lending) for a term up to about twelve months, or borrowing or investing in instruments where the interest rate varies with changes in a short-term benchmark rate of interest such as LIBOR. Where as, interest rate swaps, interest rate caps and floors options, and interest rate collar option are more applicable to hedge long-term interest rate exposures associated with borrowing or investing with bonds (Cuthberson and Nitzsche, 2001; ACCA, 2007; Gay etal, 1983). Hedging Short-term Interest Rate Risks A) Forward Rate Agreement (FRAs) Forward rate agreement is a forward contract that can be used to fix an interest rate for a future short-term loan or deposit. A FRA is not an actual short-term loan or deposit. The interest rate fixed by the FRA is on an agreed notional amount of principal, rather than an actual loan or deposit. The selected interest rate fixed by a FRA can be any benchmark rate of interest, but is usually the LIBOR rate for the term of the loan or deposit. In a FRA the buyer of the FRA agrees to pay a fixed rate of interest on the notional loan and in return to receive interest at the current market rate prevailing at the start of the

notional loan period. Conversely, the seller of the FRA agrees to receive interest on the notional loan at the fixed FRA rate, and in return to pay interest at the current market rate prevailing at the start of the notional loan period. A FRA therefore involves an exchange of interest payments, with the FRA buyer paying the fixed rate and the FRA seller paying the current market rate, whatever this happens to be when the settlement date for the contract arrives. A company can buy one or more FRAs to hedge the risk due to an increase in short-term interest rates. If the interest rates do rise, the company will have to pay the higher interest rates on its loan, but the higher interest cost will be offset by the receipt of compensation under the FRA agreement. On the other hand, if the market interest rates move favorably (down), the benefit will be offset by having to make a compensation payment to the other party to the FRA. To solidify the above points, let us assume that a company expects to borrow $10 million for three months, starting in three months' time. It wants to fix the interest rate for this borrowing, and so buys a 3 v 6 FRA on a notional principal amount of $10 million. The reference interest rate is three-month LIBOR, and the bank that sells the FRA offers a fixed rate of 5.80%. The company can borrow at 50 basis points above LIBOR. The FRA fixes the firm's borrowing rate at 5.80% plus 50 basis points, i.e. at 6.30%. Now let us assume that at the fixing date, the actual three-month LIBOR rate is 7.00%. The company will borrow $10 million at LIBOR plus 50 basis points, i.e. at 7.50%. However, it will also receive a compensation payment from the FRA bank, equivalent to the difference between the fixed FRA rate (5.80%) and the three-month LIBOR rate at fixing date (7.00%). Hence, the firms net borrowing cost is fixed at 6.30%, which is the different between firms borrowing rate at LIBOR plus 50 basis (7.50%) and compensation payment from the FRA bank (1.20%). Advantages of FRAs 1) 2) Unlike to short-term interest futures, FRAs can be tailored to the specific requirements of a customer. Unlike to short-term interest future and interest rate option, no front-end fee is payable. 3) Nothing is payable or receivable until settlement date 4) No borrowing or lending of capital is involved.

Disadvantages of FRAs 1) Over-the counter instruments cannot be re-sold in a secondary market. 2) Unlike to interest rate options (for the buyer option) FRAs are binding agreements that must be settled at the settlement date. 3) FRAs are normally more expensive than comparable interest rate futures contracts: futures might therefore be preferred when tailor-made agreements are not necessary. 4) Once purchased, it does not have a market value and cannot be traded. 5) As with futures, FRAs do not allow buyers or seller to take advantage of favorable interest rate movement (Cuthberson and Nitzsche, 2001; ACCA, 2007; Gay etal, 1983; Hull, 2000). B) Short-term Interest Rate Futures (STIRs) Short-term interest rate futures (STIRs) are standardized exchange traded forward contracts on a notional deposit of a standard amount of principal, starting on the contracts final settlement date. A hedge with STIRs offers protection against the downside risk of borrowing or investing (i.e. against risk of higher borrowing costs or lower yield). A STIRs is bought or sold such that, if the underlying cash market rate moves in an adverse direction, there will be a gain on the futures position that largely offsets the loss in the cash market. For example, if futures are used to hedge the risk of a rise in short-term interest rates on a future loan, a rise in interest rates would add to the interest cost loan, but this would be offset by a gain on the future position (as the company sales at one price to open the position and then buying at a lower price to close the position). Conversely, if the cash market interest rate moves favorably, there will be an offsetting loss on the future position. This is the case because if the interest rate falls, the price of a future will rise. To reflect this inverse relationship short-term interest rate futures are prices by subtracting the interest rate from 100. For example, if a future is traded at an interest rate of 4.00%, the price will be 96.00. Advantages of STIRs 1) The short-term interest future contracts are more liquid. 2) STIRs are extremely useful in looking in the yield to be paid to an investor or interest rate to be paid when borrowing money between two periods. Disadvantages of STIRs 1) It involves the upfront payment of a margin (initial security deposit). 2) It is available only in standard contract sizes and for a limited number of interest

rate instruments. 3) If a loss arises on the future position, there will also be a requirement to pay additional margin (variation margin) to cover the loss. 4) As with FRAs, futures do not allow buyers or sellers to take advantage of favorable interest rate movement (Cuthberson and Nitzsche, 2001; ACCA, 2007; Gay etal, 1983; Hull, 2000; Toevs and Jabcob, 1986). C) Interest Rate Options An interest rate option grants the option holder the right, but not the obligation, to deal at an agreed interest rate (the option strike rate) at a future maturity date. Interest rate options are tailor-made over-the-counter instruments. They can be purchased from major banks, with principal amounts, the length of the interest period, the currency, the exercise/expiry date and the strike rate (i.e. the rate of interest) all subject to negotiation and agreement. Interest rate options can be arranged to hedge a series of future interest periods or for a single interest period of up to one year, which is known as interest rate guarantee. Alternatively, the terms borrower's option and lender's options are used to describe single interest period interest rate options and interest rate caps and floors to describe a series of payments or receipts. In this section, borrowers and lenders option is discussed and in the next section interest caps and floors and interest collars are discussed. A borrower's option gives its holder the right, but not the obligation, to obtain a notional loan on a specified principal amount at a fixed rate of interest, which is the strike rate for the option. The notional loan has a specified starting date, which is the expiry date of the option, and a fixed term or maturity. A borrower's option is therefore a call option on a notional short-term loan. Hence, with this option, the option holder exercises the option at the expiry date if only the current market rate of interest is higher than the option strike rate. The option writer will be required to make a payment to the option holder for the difference between the market rate of interest and the strike rate. To solidify these points, assume that a company expects to borrow $ 2 million in two months time for a three-month period. It expects an increase in the LIBOR rate, which is currently 4% per annum and consequently it has decided to hedge the risk of rising interest rate using borrowers option.

It buys a borrowers option at a strike rate of 4.50%, which has a premium cost of $6,000. The option is for an expiry date in two months, and the notational interest period is threemonths. If at the expiry date, the three-month LIBOR rate is 6.50%, the option will be exercised. The company will borrow $2 million for three months at the market rate of 6.50% (LIBOR + 1%) and will receive a cash payment of $10,000 ($2 million X 3/12 X (6.50 4.50) %) from the option writer. The companys interest cost can be summarized as follows: Interest on loan ($2 million X 3/12 X 7.5%) $37,500.00 6,000.00 (10,000.00) $33,500.00 Hence, a net effective interest cost of $33,500.00 is equivalent to borrowing $2 million for three months at about ($33,500/2 million) X (12/3) X 100% = 6.7%. The option has therefore offset some of the effect of the rise in LIBOR. A lender's option gives its holder the right, but not the obligation, to make a notional loan for a specified principal amount and a specified term, starting at a future date (the option's expiry date) at a fixed rate of interest. A lender's option is therefore a put option on a notional short-term loan and the option is exercised if only the current market rate of interest is lower than the option strike rate. Advantages of Interest Rate Option 1) Unlike to FRAs and futures, option allows buyers or seller to take advantage of favorable interest rate movement while also limiting any downside losses. 2) Over-the-counter interest rate options can be tailor-made to the specific needs of the buyer. 3) Unlike to FRAs, market traded interest options may be exercised at any time. 4) Unlike to FRAs and STIRs, over-the-counter interest rate options may be arranged for longer periods. 5) Interest rate options can alternatively be used as a means of financial speculations. Disadvantages of interest rate option

Add: Cost of option (premium) Less: Cash received from option writer

1)

All options involve the payment of a premium, often upfront which is payable whether or not the option is exercised. They are expensive to buy, particularly when interest rates are volatile (Cuthberson and Nitzsche, 2001; ACCA, 2007; Gay etal, 1983; Shapiro, 2006; Gupta and Subrahmanyam, 2005).

1.1.2. Hedging Long-term Interest Rate Risks Exposure to long-term interest rate risks can be hedged using: a) Interest Rate Swap b) Interest rate caps and floors c) Interest rate collars A) Interest Rate Swap An interest rate swap is an agreement to exchange interest payments on a notional loan, normally at regular intervals for the term of the swap. Swaps are over-the-counter instruments and an important instrument for large companies to manage long-term interest rate risk and long-term currency risk. There are different types of interest rate swaps. The simplest and most common type of interest rate swap, the so-called 'plain vanilla coupon swap' or 'generic' interest rate swap. This type of swap allows two parties to exchange one element of the arrangement, a floating interest rate, for another version of the element, at a fixed interest rate. This means that one party pays the other interest on a notional loan at a fixed rate of interest, and the other party pays interest on the same notional loan amount, but at a floating rate of interest. Interest swaps offer many potential advantages to companies: 1) The ability to obtain finance cheaper than would be possible by borrowing directly in the relevant market. As companies with different credit ratings can borrow at different cost differentials in for example the fixed and floating rate markets, a company that borrows in the market where it has a comparative advantage can through swaps, reduce its borrowing cost. 2) It helps to manage the mix of fixed and floating rate interest in the companys debt mix. If interest rates are expected to rise, a company might want to switch from borrowing at a floating rate to borrowing at todays fixed rates. If interest rates are expected to fall, however, a company might want to switch from fixed to floating rate borrowing.

3) It helps to obtain fixed rate borrowing commitments when the company lacks access to capital market either due to its low credit rating or it is relatively unknown in the market by swapping floating interest rate by fixed rate of interest. 4) Interest rate swaps can be arranged for up to ten years, which can provide protection against interest rate movements for much longer periods than the FRAs, Interest rate options and STIRs. 5) Interest rate swaps are relatively to other hedging techniques easy to arrange, transactions costs are low and tailor made and if required they can be reversed. 6) Unlike to futures and options, there is no upfront payment in swaps. Disadvantages of interest rate swap 1) Unlike to interest rate options, swaps dont allow buyers or sellers to take advantage of favorable interest rate movements while also limiting any downside losses. 2) Interest rate swaps involve credit risk (default risk) and market risk (the risk that interest rate will move unfavorably against the company). 3) The other major problem with selling a swap is that the two initial parties had approved each other's credit status, and the buyer of the swap may not be acceptable to the original counterparty. The counterparty may agree to review the buyer's credit, but such an analysis raises the cost of the swap. An example of a basic interest rate swap clarifies the potential benefits and costs of swap. Borrower A, who wants a fixed rate obligation, can borrow at a fixed rate of a 10% or a floating rate of LIBOR + 1%. Borrower B, who wants a floating rate obligation, can borrow at a fixed rate of 8% and a floating rate of LIBOR + 0.5%. Borrower A borrows floating rate (LIBOR + 1%) and borrower B fixed rate debt (8%) and then they swap their interest rate obligations. Their agreement stipulates that borrower A pays borrower B 9% and receives in return LIBOR + 0.5%. This means that borrower A borrows at LIBOR + 1% but receives a fixed rate obligation that costs it 9.5%, thereby saving 0.5%, and borrower B borrows at 8% but receives a floating rate obligation that costs it LIBOR 0.5% (the LIBOR + 5% it pays borrower A minus 1%, which is the difference between its 8% fixed rate loan and the 9% borrower A pays it) (Arnold, 1984; ACCA, 2007; Gay etal, 1983; Bisky, 1982; Daigler 1988). B) Interest Rate Caps and Floors In the previous section, it has been discussed an over-the-counter borrowers and lenders

option contract to lock in either a maximum borrowing rate or a minimum lending rate on a single future cash flow at one fixed future date. However, if a company wants to lock in a series of payments or receipts over successive known future dates, it is possible to use interest rate caps and floors and interest rate collars. An interest rate cap is a series of call options (borrowers options) on a notional amount of principal, exercisable at regular intervals over the term to expiry of the cap. The cap holder has the right to exercise the option at each interest fixing date or rollover date for the loan. The effect of cap is to place an upper limit on the interest rate to be paid, and therefore useful to the borrower of funds who will be paying interest at a future date. An interest rate floor is a series of put options (lender options) that sets a minimum interest rate (the strike rate) on deposit. The floor holder has the right to exercise the option at each interest fixing date or rollover date for the loan. The advantages and disadvantages of interest rate options discussed in the previous section are also applicable to interest rate caps and floors as they are in most respect similar to borrowers and lenders option, except the fact that, the cash settlement when the option is exercised is paid at the end of the interest period in the case of caps and floors, but at the beginning of the interest period under borrowers and lenders option. As a result the cash settlement is not discount to a present value. The other difference is that borrowers and lenders options are mainly used to hedge short term interest fluctuations, where as caps and floors are used to hedge long-term interest rate fluctuations. Over-thecounter caps and floors are available for periods of up to ten years and can thus protect against long-term interest rate movements (Cuthberson and Nitzsche, 2001; ACCA, 2007; Gay etal, 1983; Hull, 2000; Gupta and Subrahmanyam, 2005).

C) Interest Rate Collars One of the main disadvantages of interest rate option so far discussed is the payment of premium. Even if interest rate caps and floors are useful in hedging long-term interest rate movement, they are very expensive to use. If a company doesnt want to pay high premium, but wish to hedge its interest rate risk, the alternative it has is to use interest rate collars option. An interest rate collar option reduces the premium cost by limiting the possible benefits of favorable interest rate movement. A collar involves the simultaneous purchase and sale of options. For instance, when a borrower buys a collar, he is buying cap at one strike rate but at the same time is selling a floor at a lower rate. Hence, the cost of a collar is the difference between the premium payable on the cap and the premium receivable from selling the floor. If the cost of the cap is offset exactly by the sale value of the floor, then the collar is known as a zero cost collar (Cuthberson and Nitzsche, 2001; ACCA, 2007; Gay etal, 1983; Hull, 2000; Gupta and Subrahmanyam, 2005).

Conclusions All firms-domestic or multinational, small or large, leveraged or unleveraged- are sensitive to interest rate movements in one-way or another. They have some exposure to interest rate risk if they have any asset that earn interest or any on which interest is paid. Interest rate risk can be significant for companies with massive financial assets and liabilities unless it is properly managed or hedged. Short-term interest rate risk can be hedged by using forward rate agreement, short-term interest futures, and borrower and lenders interest rate options. Forward rate agreement is a forward contract where by the buyer of the FRA agrees to pay a fixed rate of interest on the notional loan and in return to receive interest at the current market rate; and the seller agrees to receive interest on the amount at a fixed FRA rate and in return to pay interest at the current market rate. FRAs have advantages of being tailored to the specific requirements of a customer, and they involve no front-end or settlement date payment. However, FRAs are more expensive than comparable interest rate futures and cannot be re-sold in a secondary market. Short-term interest futures (STIRs) are standardized exchange traded forward contracts on

a notional deposit of a standard amount of principal, starting on the contracts final settlement date. STIRs are bought or sold such that, if the underlying cash market rate moves in an adverse direction, there will be a gain on the futures position that largely offsets the loss in the cash market. STIRs are more liquid, but they are available only in standardized contract size and involve the upfront payment of a margin. Borrowers and lenders option grants the option holder the right, but not the obligation, to deal at an agreed interest rate (the option strike rate) at a future maturity date. This method allows buyers or seller of the option to take advantage of favorable interest rate movement while also limiting any downside losses by paying premium for having that right. Long-term interest rate risk can be hedged using interest rate swaps, interest rate caps and floors option, and interest rate collars option. An interest rate swap is an agreement to exchange interest payments on a notional loan, normally at regular intervals for the term of the swap. For instance, to exchange one element of the arrangement, a floating interest rate, for another version of the element, a fixed interest rate. Interest rate swaps help companies to obtain finance cheaper, to manage the mix of fixed and floating rate interest, and to obtain fixed rate borrowing commitments. Nevertheless, interest rate swaps involve credit risk, market risk and unlike to options they dont allow the parties to take advantage of favorable interest rate movement while also limiting any downside losses. An Interest rate caps are series of borrowers option that sets a maximum interest rate (the strike rate) on the loan. Where as, an interest rate floor (lenders option) sets a minimum interest rate on the deposit. In both cases, the holder has to pay premium to have the right to exercise the option at each interest fixing date or rollover date for the loan or deposit. To reduce the premium cost by limiting the possible benefits of favorable interest rate movement, the company may use an interest rate collar option, which involves the simultaneous purchase and sale of options.

References
ACCA (2007). Berkshire. Strategic Financial Management. Kaplan Publishig Foulks Lynuch:

Alan C. Shapiro (2006). Multinational Business Finance, 8th edition. John Wiley and Sons: Botson. Anurag Gupta and Marti G. Subrahmanyam (2005). Pricing and Hedging Interest Rate Options: Evidence From Cap-Floor Markets. Journal of Banking and Finance, Vol. 29, pp 701-733. David K. Eiteman, Arthur L. Stonehill and Michael H. Moffett (2004), Multinational Business Finance, 10th edition. Pearson Additional Wesley: Boston. Gay, G.D, Kolb, R.W, abd Chiang R. (1983). Interest Rate Hedging: An Empirical Test of Alternative Strategies. Journal of Financial Research, Vol. 6, pp.187-197. Hull J. White (2000). Forward Rate Volatilities, Swap Rate Volatilities, and the Implementation of LIBOR Market Model. Journal of Fixed Income 10, pp. 4662. Hull J.C. (2000), Options, Futures and Other Derivates. 4th edition, Prentice Hall International: London. Jeff Madura. (1995). International Financial Management. West Publishing Company: NewYork. Keith Cuthberson and Dirk Nitzsche (2001). Financial Engingeering: Derivatives and Risks Management. John Wiley and Sons, Ltd: Chichester. Robert T. Daigler (1988). Interest Rate Swaps and Financial Institutions. Financial Executives, October, pp. 30-62. Tanya S. Arnold (1984). How to Do Interest Rate Swaps. Harvard Business Review, Sept-Oct. Timan, S. (1992): Interest Rate Swaps and Corporate Finance Choices, Journal of Finance, Vol 47, 1503-1516. Tom Bisky (1982). Eurobonds: Swap of Interest Rate Aids Firms in Getting Fixed Rate Financing. Wall Street Journal, July 26. Toevs, A. and Jabcob D. (1986). Futures and Alternative Hedge Methodologies. Journal of Portfolio Management, Spring, pp.60-70.