Actively configure the interest positions

The high mobility of international capital results in considerable fluctuations in the short and long-term interest rates.
Interest risk management is therefore a central element of entrepreneurial activity and offers a host of possibilities through the rapid development of the derivative markets (derivative = transaction derived from underlying transactions such as a loan or investment). The goal of every company should therefore be to actively configure the interest positions within the framework of the interest risk management in order to maximise the value of these positions and thus the value of the company.

The interest risk management not only includes a financing or investment decision but also means:

  • Managing interest risks independently of liquidity risks
  • Implementing interest opinions or expectations accordingly or adapting them to amended market situations
Interest rate swap

With an interest swap, two partners agree to an exchange (swap) of

  • interest payments with a different configuration
  • over a certain period of time
  • without any transfer of the underlying capital.

The swap is limited to the interest payments. The underlying capital amounts are not swapped as their amounts are identical. They serve merely as a calculation parameter for the interest rate payments. The swap partners agree to interest payments that have resulted from a take-up or investment of funds with different fixed interest rate periods. In the process, fixed interest rates are swapped for variable interest rates. The variable interest rates are linked to a reference interest rate that is transparent for all parties, e.g. EURIBOR (Euro Interbank Offered Rate) or LIBOR (London Interbank Offered Rate), with a corresponding term, the fixed interest rate period.

Application example

With the financing, e.g. with a loan in EUR on a variable basis, the company has the risk with increasing market interest rates that the financing will become more expensive from the following interest rate adjustment date (roll-over). With a swap, this risk of the interest rate from the underlying transaction changing can be eliminated.

Interest rate cap & interest rate floor

The cap is an interest rate option. An option denotes a right to purchase or sell a certain item at a later point in time for an agreed price. A cap constitutes a contractual agreement in which the buyer is guaranteed an upper interest rate limit in return for the payment of a premium. This results in the burden from an already existing liability with variable interest, or one that still has to be taken out, not exceeding this defined upper rate limit during the term (interest rate hedging). The seller thus undertakes to compensate an additional burden that goes beyond this upper interest rate limit with a payment to the buyer.

The counterpart to the cap is the floor. When a floor is concluded, a lower interest rate limit is contractually agreed. The consequence is that the income from e.g. an existing investment with variable interest or one that is still to be made does not fall below this defined lower interest rate limit. The buyer of a floor acquires from the seller the right to a compensation payment if during the agreed term of the floor a previously defined reference interest rate falls below a specified agreed lower limit. For this, the buyer pays a one-off premium to the seller when the contract is concluded.

When a cap or floor is concluded, buyer and seller agree

  • the term
  • the upper interest rate limit with a cap and the lower interest rate limit with a floor
  • the reference interest rate
  • the underlying nominal amount
Payer swaption

The term “swaption” is derived from swap option. A swap is an exchange, cf. also interest rate swap. An option denotes a right to purchase or sell a certain item at a later point in time for an agreed price.

A swap option is an agreement that gives the buyer the right, but not the obligation, to buy a swap. In the swap, the buyer buys the fixed swap rate defined when the swaption is concluded and in return receives the variable interest rate. The option can be exercised at the end of the option term.

Application example

In connection with a bidding procedure, a company wishes to secure financing costs for itself that can be calculated at fixed rates. Due to the risk of the interest rate changing, the company wishes to protect the current interest rate level without any purchase obligation, i.e. the financing will not be required if the contract is not awarded. For protection, the company buys a payer swaption.

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