Managing Interest Rate Risk

Financial intermediaries encounter five general risk types:

Interest rate risk

Price risk

Prepayment risk

Credit risk

Exchange-rate risk

Interest rate risk is that which exists in an interest-bearing asset, such as a loan or a bond, due to the
possibility of a change in the asset's value resulting from the variability of interest rates. Interest rate
risk management has become very important, and assorted instruments have been developed to deal
with interest rate risk. This article examines the management of interest rate risk with the use of
various interest rate derivative instruments. (For related reading, see How Interest Rates Affect the
Stock Market.)

Why Interest Rate Risk Should Not Be Ignored?

As with any risk management assessment, there is always the option to do nothing, and that is what
many people do. However, in circumstances of unpredictability, sometimes not hedging is disastrous.
Yes, there is a cost to hedging, but what is the cost of a major move in the wrong direction?
One need only look to Orange County, California, in 1994 to see evidence of the pitfalls of ignoring
the daunting threat of interest rate risk. In a nutshell, County Treasurer Robert Citron borrowed
money at lower short-term rates and lent money at higher long-term rates. The strategy was great short-term rates fell and the normal yield curve was maintained - but, when the curve began to turn
and approach inverted yield curve status, things got ugly. Losses to Orange County and the almost
200 public entities for which Citron managed money were estimated at $1.6 billion and resulted in
the bankruptcy of the municipality - a hefty price to pay for ignoring interest rate risk. (Read about
another financial meltdown in Orange County in The Rise and Demise of New Century Financial.)

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Luckily, those who do want to hedge their investments against interest rate risk have many products
to choose from. These will be examined in turn below.

Investment Products

Forwards

A forward contract is the most basic interest rate management product. The idea is simple, and many
other products discussed in this article are based on this idea of an agreement today for an exchange
of something at a specific future date.

Forward Rate Agreements (FRAs)

An FRA is based on the idea of a forward contract, where the determinant of gain or loss is an
interest rate. Under this agreement, one party pays a fixed interest rate and receives a floating interest
rate equal to a reference rate. The actual payments are calculated based upon a notional principal
amount and paid at intervals determined by the parties. Only a net payment is made - the loser pays
the winner, so to speak. FRAs are always settled in cash.
FRA users are typically borrowers or lenders with a single future date on which they are exposed to
interest rate risk. A series of FRAs is similar to a swap (discussed below); however, in a swap all
payments are at the same rate. Each FRA in a series would be priced at different rates, unless the
term structure is flat.

Futures

A futures contract is similar to a forward, but provides the counterparties with less risk than a
forward contract, namely a lessening of default and liquidity risk, due to the inclusion of an
intermediary. (Those who are new to futures but want a solid understanding of them should read our
tutorial on Futures Fundamentals.)

Swaps

Just like it sounds, a swap is an exchange. More specifically, an interest rate swap looks a lot like a
combination of FRAs and involves an agreement between counterparties to exchange sets of future
cash flows. The most common type of interest rate swap is a plain vanilla swap, which involves one
party paying a fixed interest rate and receiving a floating rate and the other party paying a floating

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rate and receiving a fixed rate. (Learn how these derivatives work and how companies can benefit
from them in An Introduction to Swaps.)

Options

Interest rate management options are option contracts whose underlying security is a debt obligation.
These instruments are useful in protecting the parties involved in a floating rate loan, such as
adjustable-rate mortgages (ARMs). A grouping of interest rate calls is referred to as an interest rate
cap; a combination of interest rate puts is referred to as an interest rate floor. In general, a cap is like
a call and a floor is like a put.
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Swaptions: A swaption, or swap option, is simply an option to enter into a swap.

Embedded options: Many investors encounter interest management derivative instruments via
embedded options. If you have ever bought a bond with a call provision, you too are in the club.
The issuer of your callable bond is insuring that if interest rates decline, they can call in your
bond and issue new bonds with a lower coupon. (To learn more, read The Four Advantages of
Options.)

Caps: A cap, also called a ceiling, is a call option on an interest rate. An example of its
application would be a borrower going long, or paying a premium to buy a cap and receiving
cash payments from the cap seller (the short) when the reference interest rate exceeds the strike
rate of the cap. The payments are designed to offset interest rate increases on a floating-rate loan.

If the actual interest rate exceeds the strike rate, the seller pays the difference between the strike and
the interest rate multiplied by the notional principal. This option will "cap", or place an upper limit,
on the interest expense of the holder.
The interest rate cap is actually a series of component options, or "caplets," that exist for each period
the cap agreement is in existence. A caplet is designed to provide a hedge against a rise in the
benchmark interest rate, such as the London Interbank Offered Rate (LIBOR), for a stated period.
(For more on using benchmarks to quantify risk, read Measuring And Managing Investment Risk.)
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Floors: Just as a put option is considered the mirror image of a call option, the floor is the mirror
image of the cap. The interest rate floor, like the cap, is actually a series of component options,
except that they are put options and the series components are referred to as "floorlets". Whoever
is long the floor is paid upon maturity of the floorlets if the reference rate is below the strike
price of the floor. A lender uses this to protect against falling rates on an outstanding floating-rate
loan.

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Collars: A protective collar can also be used in the management of interest rate risk. Collaring is
accomplished by simultaneously buying a cap and selling a floor (or vice versa), just like a collar
protects an investor who is long a stock. A zero cost collar can also be established in order to
lower the cost of hedging, but this lessens the potential profit that would be enjoyed by a
movement in interest rates in your favor, as you have placed a ceiling on your potential profit.
(For related reading, see Don't Forget Your Protective Collar.)

Conclusion
These products all provide ways to hedge interest rate risk, with different products being appropriate
for different scenarios. There is, however, no free lunch. With any of these alternatives, one gives up
something - either money (premiums paid for options) or opportunity cost (the profit one would have
made without hedging).

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