Understanding Interest Rate Risk

Gives an introductory understanding of why different business units care about interest rate risk and how they can address it.

Interest rate changes affect returns on bonds and other fixed income assets, in which a lot of people nearing retirement would have their money invested. But volatility in interest rates also affect non-investment businesses which then indirectly affect the prices that we pay for products that we consume.

There are different businesses units that care about interest rate risk. Some businesses hurt when rates go down, while others care if the rates go up. The fact that different businesses have different concerns on interest rate movements mean that hedging strategies can be employed. In some sense, hedging is a way of distributing risk from one entity to others. When all is well, this can be a great thing for your business. The concept or interest rate risk management involves understanding, quantifying and hedging interest rate risk.

Who cares about interest rate risk?

There are different industries and businesses that are affected by interest rate fluctuations. Let us look at a few examples.

• Fixed Income Investors: Funds that we contribute to our retirement accounts or pension plans are invested in equity and fixed income funds. Fixed income investors purchase bonds which are affected by interest rate fluctuations. Price of a fixed income bond is (generally) inversely propotional to interest rate movements, i.e. the value of the investment drops when interest rates rise and gains when interest rates drop. The sensitivity of fixed income investment to interest rate depends on the asset's maturity. Longer maturity investments are more sensitive to interest rate changes than short maturity investments.

• Mortgage Lenders & Servicers: Mortgage lenders allow prospective home buyers to lock in on a mortgage rate for a couple of months. Lets say, that the lender has provided the home buyer a locked mortgage rate for a loan of \$100,000. But in 2 months time, when the home buyer closes on the loan, should the interest rates rise, then mortgage loan is worth less than \$100,000 and the lender stands to lose when he sells in the secondary market. Similarly, on the mortgage servicing side, when interest rates go down, the loans in the servicing portfolio could drop out due to interest rate refinancing. This can lead to decrease in projected cashflows.

• Small and Large Businesses: Businesses need to raise capital in order to expand, and very often do so by using loans from financial institutions. The loans given out to small to medium businesses typically carry floating rate payments. Because of a variable interest rate loan, businesses are exposed to the interest rate fluctuations.

Addressing Interest Rate Risk

There are various tools available to market practitioners to mitigate exposure to interest rate risks. Derivative contracts such as interest rate swaps allow two parties to exchange cashflows such as fixed to float, or float on one tenor with float on another tenor. By entering a fixed for float swap, businesses can convert a floating payment on their loans into a net fixed payment.

Futures contracts on interest rate with different maturities on the deliverable allows one to hedge interest rate risk exposure on their books. The Futures contracts are exchange traded and offer liquidity and do not have credit risk associated.

Conclusion

In this blog post, I provided an introduction to interest rate risk and how it can be managed. At a later post, I will drill into some of the specifics of how certain derivatives can help hedge interest rate risk.

   hedging   finance   risk management  

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