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Instruments of interest risk management

Interest rate risk management  is a central element of business, and offers a wide variety of options due to the rapid development of the derivatives market (a derivative is a transaction based on an underlying transaction such as a loan or investment). It not only includes a financing or investment decision, but also means:

  • Controlling interest rate risks separately from liquidity risks.
  • Acting in accordance with interest rate expectations and adapting to changed market conditions.

The high mobility of international capital causes significant fluctuations in short- and long-term interest rates. For this reason, every business should strive to actively manage its interest rate positions through suitable tools and instruments, maximizing the value of its interest rate position and of the company itself.

Interest rate swap

With an interest rate swap two partners agree to swap

  • interest payments of different structures
  • over a certain period
  • and without transferring the underlying capital.

The swap in this instance only relates to the interest payments. The underlying amounts of capital are not swapped as they are of the same amount, their only purpose is to facilitate the calculation of the interest payments. The swap partners agree on the interest payments that are the result of a loan or an investment under different interest terms and conditions. A fixed interest rate is swapped for a variable interest rate. The variable interest rates are tied to a reference interest rate that is transparent for all parties involved, e.g. the EURIBOR (European Interbank Offered Rate) or the LIBOR (London Interbank Offered Rate), with corresponding terms and interest rate lock-in periods.

In the case of a loan taken out in euros for instance with a variable rate of interest, a company faces the risk of seeing market interest rates rise and thus the loan becoming more expensive from the next roll-over date. A swap transaction eliminates this risk of a change in the interest rate from the underlying transaction.

Interest rate cap and interest rate floor

A cap is an interest option. An option describes the right to buy or sell a given item at a later date and at an agreed price. A cap is a contractual agreement whereby upon payment of a premium the buyer is guaranteed a maximum interest rate. This means that the charge from an existing or future liability with a variable rate of interest will not exceed this set interest rate cap in the course of the term (interest rate hedge). The seller undertakes to compensate the buyer for any additional charge over and above the interest rate cap by making a payment to the buyer.

The opposite to a cap is a floor. With an interest rate floor, a contractual agreement is made for a minimum interest rate. This means that the income from an existing or future investment with variable interest for example may not fall below this set minimum interest rate. The buyer of an interest rate floor acquires a right from the seller to a compensation payment if a pre-defined reference rate of interest falls below a minimum level, also determined in advance, over the duration of the floor. To this end the buyer pays the seller a one-off premium when concluding the contract.

When entering into a cap or floor agreement the buyer and the seller agree on

  • the term.
  • the maximum interest rate for the cap or the minimum interest rate for the floor.
  • the reference interest rate.
  • the underlying nominal amount of capital.

A company has taken out a loan on the money market for 3 years. It wants to protect itself against rising interest rates on the money market, without foregoing the opportunity to benefit from falling money market rates. By buying an interest rate cap the company can set a maximum interest rate for the coming years in respect of the underlying liability.

Payer swaption

The concept of a swaption is derived from swap option. For more information on swaps see Interest Rate Swap. An option describes the right to buy or sell a given item at a later date and at an agreed price.

A swaption is an agreement where the buyer is entitled – but not obliged – to buy a swap. In the swap the buyer pays the fixed leg agreed in the swaption and receives the floating leg in return. The option can be exercised at the end of the option term.

A company wants to ensure fixed and predictable financing costs in connection with a bidding procedure. In view of the risk of a change in interest rates the company wants to secure the current interest rate without any commitment, i.e. if they do not win the contract then the financing is not required. To achieve this, the company buys a payer swaption.