| The traditional method of managing interest rate risk | | | | representing the difference between the FRA rate |
| has been fixed -rate borrowing in the form of loans . | | | | & the actual rate. |
| If is simple , & companies know how much they | | | | Example--- |
| will need each year to service the debt, However, it | | | | Thomas plc has $ 1 m loan outstanding on which the |
| is not always possible to obtain a loan at the rates, | | | | interest rate is reset six months for the following six |
| or for the amounts required. | | | | months. And the interest is payble at the end of that |
| An enterprise may wish to take precautions against | | | | six month period. |
| interest rates moving up or down in the future , or | | | | The next six monthly reset period may now be just |
| many wish to change the existing structure of its | | | | three months away , but the treasurer of Thomas |
| funding or deposits , for instance for a fixed rate of | | | | plc thinks that interest rates are likely to rise |
| interest to a floating rate. With the devolopmentof | | | | between now & then. Current six month rates |
| the financial markets & , in particular , the | | | | are 8% & the treasurer can get a rate of 8.1% |
| financial futures markets , a number of instruments | | | | for a six month FRA starting in three months time. |
| have arisen which allow the treasurer to hedge | | | | By transactions an FRA the treasurer can lock in a |
| interest rate risk. | | | | rate today of 8.1%. If interest rates rise as expected |
| Interest Rate Swaps. | | | | to say 9% Thomas plc has reduce its interest charge |
| An interest rate swap is an exchange of interest rate | | | | as it will pay the current 9% rate on its loan but will |
| commitments , serch that a fixed -rate. | | | | recive from the FRA counterpart the difference |
| Commitment is exchanged for a floating-rate | | | | between 9% & 8.1%. |
| commitment. The parties to a swap retain their | | | | If however rates drop to 7% Thomas plc will still end |
| obligations to the orginal lenders . Which means that | | | | up paying an effective rate of 8.1% because |
| the swap parties must accept counter - party | | | | although the interest rate on the loan is lower , the |
| risk.Interest rate swaps are used for purposes other | | | | company will pay the FRA counterpart the difference |
| than obtaining a cheaper financing rate. They could , | | | | between 7% & 8.1%. |
| for example- be used to change future case flows or | | | | If rates are 9% in three months time, $ |
| to enhance returns.Interest rate swaps are off | | | | Interest payable on the loan 9% x $1 m x 6 |
| balance sheet items , as the principal amount of the | | | | 12------------------------------------------ 45000 |
| contract is not paid , & it is just an agreement | | | | Amount receivable on FRA (9%-8.1%)x$1 m x 6 |
| to swap future cash flows. However, the existece of | | | | 12------------------------------------ (4500)net amount |
| the swap should be maintained in the notes to the | | | | 40500 |
| financial statements. The interest payments & | | | | The 40500$ is the net amount payable , giving an |
| receipts should be accrued over the life of the swap | | | | effective rate of 8.1%, If rates are 7% in three |
| on a straight-line basis. Financial institutions which | | | | months time |
| actively trade swaps revalue their positions the | | | | $ |
| current market value. | | | | Interest payable on the loan 7% x $1m x6 |
| Forward Rate Agreements. | | | | 12--------------------------------------------35000 |
| A forward rate agreement ( FRA) is an agreement | | | | Amount payable on FRA ( 8.1% - 7%) x $ 1m x 6 |
| whereby an enterprise can lock in an interest rate | | | | 12--------------------------------------5500net |
| today for a period of time starting in the future. On | | | | ----------40500 |
| the future date the two counter parts in the FRA | | | | The $ 40500 is the net amount payble , again giving |
| settleup & , depending on which way rates go , | | | | an effective rate of 8.1%. |
| one will pay an amount of money to the other | | | | |