Interest Rate Risk Management

• Treasury Management Module 2A covers the management and reporting of foreign exchange and interest rates exposures with a focus on interest rate risk.

Interest Risk Management Objectives

• Interest rate risk refers to the possible negative impact on a company's profits due to changes in interest rates.
• Companies incur interest rate risk when borrowing or extending credit.
• A small hike in interest expense could significantly negatively impact profits for companies with large outstanding debt.
• For example, an investor buys a five-year, P50k bond with a 3% coupon.
• If interest rates rise to 4%, the investor will have trouble selling the bond due to more attractive newer bond offerings.
• Lowered demand will also trigger lower prices on the secondary market, potentially causing the bond's market value to drop below its original purchase price.

Types of Interest Rate Risk

• Various types of interest rate risk exist for firms to consider, arising from mismatches in the repricing of assets and liabilities, along with other factors.
• Repricing risk is the risk of changes in interest rate charged or earned when a financial contract's rate is reset, emerging when interest rates are settled on liabilities for periods that differ from those on offsetting assets.
• Basis risk is the relationship between the cash price and future price of an underlying asset. Variations occur when there are differences in delivery location, quality, and date/time.
• An investor can quantify basis risk by subtracting the futures price of the contract from the current market price of the asset being hedged.
• With oil at $55 per barrel and a futures contract at $54.98, the basis $0.02.
• Reinvestment risk represents the chance that cash flows received from an investment earn less when reinvested, thus creating an opportunity cost.
• Callable bonds face a particular vulnerability to reinvestment risk because they are typically redeemed when interest rates decline.

Mitigating Interest Rate Risk

• The common tools for interest rate mitigation include diversification and hedging.

Diversification

• Diversification is a risk management strategy that establishes a mix of investments within a portfolio.
• A diversified portfolio contains a mix of distinct asset types and investment vehicles to limit exposure to any single asset or risk.
• Asset allocation for a conservative portfolio may include 50% in bonds, 30% in short-term investments, and 20% in stocks.

Hedging

• Interest rate risk can be mitigated through hedging strategies, including the purchase of different types of derivatives.
• The most common examples include interest rate swaps, options, futures, and forward rate agreements (FRAs).
• Hedging limits losses and acts as insurance against adverse price changes.
• Futures contracts, agreements to buy or sell assets at a future date for a predetermined price, are often used for hedging purposes.
• A futures contract is an agreement between two parties for the future purchase and delivery of an asset at an agreed-upon price.
• Futures are standardized and traded on an exchange, used as a tool the traders use to hedge risk or speculate on the price of an underlying asset.
• Involved parties are obligated to fulfill a commitment to buy or sell the underlying asset.
• On Nov. 6, 2023, Company Altha buys a futures contract for oil at a price of $62.22 per barrel that expires Dec. 19, 2023, due to Altha's need for December oil and concern that prices will rise before then.
• Buying an oil futures contract hedges Altha's risk, as the seller must deliver oil to the Altha for $62.22 per barrel once the contract expires.
• If oil prices rise to $80 per barrel by Dec. 19, 2023, Altha could accept the oil delivery, but can also sell the contract before expiration and seize profits if the oil is no longer needed.
• Both the futures buyer and seller hedge their risk in the example.
• In December 2023 that Company Altha will need oil in the future because they wanted to offset the risk that the price may rise with a long position in an oil futures contract.
• The seller may be an oil company that will has had a concern about falling oil prices by wanted to eliminate that risk via selling or shorting a futures contract. They would fix the price in December 2023.
• Forward contracts are similar to futures, although they are not traded on an exchange.
• These contracts trade over-the-counter (OTC), and offer the flexibility for the buyer and seller to customize terms, size, and settlement. OTC products, forward contracts carry a greater degree of counterparty risk for both involved parties.
• Counterparty risks are a type of credit risk involving the potential inability of parties to fulfill their contract obligations.

Swaps and Options

• Swaps are a common type of derivative that can be used to exchange financial features such as interest rate types.
• A trader might use an interest rate swap to switch from fluctuating variable interest rate loan to a stable fixed interest rate loan, or vice versa.
• Company Beta borrows Php 1,000,000 at a fluctuating interest rate that is currently 6%.
• To to mitigate interest rate risk Company Beta may use a swap.
• Beta creates a swap with Company Alpha, which is willing to exchange the variable-rate loan payments for fixed-rate loan payments at 7%.
• Beta will pay 7% to Alpha on its Php 1,000,000 principal, and Alpha will pay Beta 6% interest on the same principal.
• At the start of the swap, Alpha will pay Beta the 1 percentage-point difference between the two swap rates.
• Company Beta will pay Alpha the 2 percentage-point difference on the loan with the original variable rate dropping to 5%.
• If interest rates climb to 8%, Alpha would have to pay Beta the 1 percentage-point difference.
• As a result, the swap will achieve Beta's original objective of turning a variable-rate loan into a fixed-rate loan, irrespective of changes to interest rates.
• An options contract is similar to futures, involving an agreement between two parties to buy or sell an asset at a predetermined future date for a specific price.
• Options hold the key difference from futures, that with an option, the buyer is not obligated to exercise their agreement to buy or sell.
• Options can be used to hedge or speculate on the price of the underlying asset, as futures.
• A "call option" confers the right to buy a stock at the strike price before the agreement expires.
• A "put option" gives the holder the right to sell a stock at a specific price.
• For example, an investor buys a call option to buy Omega stock at a Php 50 strike price sometime during the next three months, when the stock trades at Php 49.
• Then, if the stock jumps to Php 60, the call buyer can exercise the right to buy the stock at Php 50 and immediately sell the stock for Php 60, making a Php 10 profit per share.
• The option buyer can sell the call and pocket the profit.
• If the option is trading below Php 50 at the time the contract expires, the option is worthless and the buyer loses upfront payment for the option.

Reminders

• Module 2B is a lecture on Foreign Exchange Risk.
• Quiz #1 is on March 23rd.