CIMA F3 Syllabus B. Sources of long term funds - Interest rate risk management - Notes 10 / 15
Interest rate risk management
If the organisation faces interest rate risk, it can seek to hedge the risk.
Alternatively where the risk is immaterial in comparison with the company's overall cash flows or appetite for risks, one option is to do nothing.
The company then accepts the effects of any movement in interest rates which occur.
The company may also decide to do nothing if risk management costs are excessive, both in terms of the costs of using derivatives and the staff resources required to manage risk effectively.
Interest Rate Risk
Fixed rate borrowing - risk that variable rates drop
Variable rate borrowing - risk that variable rates rise
Methods of reducing interest rate risk include the following:
Netting
- aggregating all positions, assets and liabilities, and hedging the net exposure
Smoothing
- maintaining a balance between fixed and floating rate borrowing
Matching
- matching assets and liabilities to have a common interest rate
Forward rate agreement (FRA)
- a binding contract that fixes an interest rate for short-term lending/investing or short-term borrowing, for an interest rate period that begins at a future date
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 to hedge against interest rate rises. Lenders buy futures to hedge against Interest rate falls.
Interest rate options
- an interest rate option grants the buyer of it the right, but not the obligation, to deal at an agreed interest rate (strike rate) at a future maturity date
Interest rate swaps