Interest rate risk 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 introduces you to ways that both businesses and consumers manage interest rate risk using various interest rate derivative instruments. 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, Calif. In a nutshell, Orange 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. Luckily, those who do want to hedge their investments against interest rate risk have many products to choose from. 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. 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 is priced at a different rate, unless the term structure is flat. Futures A futures contract is similar to a forward, but it 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.

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 rate and receiving a fixed rate. Options Interest rate management options are option contracts for which 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.

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.

Hedging techniques for interest rate risk | ACCA Qualification | Students | ACCA Global

This option will "cap," or place an upper limit, on the holder's interest expense. The interest rate cap is actually a series of component options, or "caplets," for each period the cap agreement exists. 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.

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. Dictionary Term Of The Day. A measure of what it costs an investment company to operate a mutual fund.

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Managing Interest Rate Risk By Helen Simon Share.

Investment Products Forwards A forward contract is the most basic interest rate management product. 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 on 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.

Interest Rate Options vs. FRAs

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. Caps A cap, also called a ceiling, is a call option on an interest rate.

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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 cap's strike rate. The payments are designed to offset interest rate increases on a floating-rate loan. 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. A lender uses this to protect against falling rates on an outstanding floating-rate loan. Collars A protective collar can also help manage 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 to lower the cost of hedging, but this lessens the potential profit that would be enjoyed by an interest rate movement in your favor, as you have placed a ceiling on your potential profit.

An interest rate swap is an exchange of future interest receipts. Essentially, one stream of future interest payments is exchanged for another, based on a specified principal amount. When trading in financial markets, higher returns are generally associated with higher risk.

Hedge your risk with interest rate swaps. Learn how these derivatives work and how companies can benefit from them. The swap market plays an important role in the global financial marketplace; find out what you need to know about it.

Puzzled by interest rate swap quotes terminology? Investopedia explains how to read the interest rate swap quotes. Learn how to use this type of investment as an alternative way to participate in the market.

Plain interest rate swaps that enable the parties involved to exchange fixed and floating cash flows. The wrong currency movement can crush positive portfolio returns.

How are futures used to hedge a position?

Find out how to hedge against it. Learn about the different ways investors can reduce interest rate risk.

Locking in interest rates increases certainty for Find out how individual investors can speculate on interest rate movements through interest rate swaps by trading fixed rate An interest rate swap involves the exchange of cash flows between two parties based on interest payments for a particular An absolute rate is easy to understand once you know the basics of an interest rate swap.

An absolute rate is the fixed rate Learn about interest rate swaps and how they are traded over the counter, and understand the impact of Dodd-Frank on swaps Read about interest rate swaps and why these transactions are performed by institutional actors in the bond market, not individual An expense ratio is determined through an annual A hybrid of debt and equity financing that is typically used to finance the expansion of existing companies.

A period of time in which all factors of production and costs are variable. In the long run, firms are able to adjust all A legal agreement created by the courts between two parties who did not have a previous obligation to each other. A macroeconomic theory to explain the cause-and-effect relationship between rising wages and rising prices, or inflation.

A statistical technique used to measure and quantify the level of financial risk within a firm or investment portfolio over No thanks, I prefer not making money.

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