Large companies try to manage their exposure to changes in interest rates. Treasurers in large companies regularly use forward markets, swaps and options to hedge against risk. Whilst these are vehicles that are used to try to avoid risk, they can be risks in themselves.
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The forward markets
Using the forward markets can help a company to limit its exposure to interest rates. It is possible to both borrow and lend money forward – agreeing a rate of interest for a loan that will start in the future. This type of agreement has become less common and has now largely been replaced by forward rate agreements (FRAs). FRAs are simply contracts between two parties to exchange cash amounts that compensate for any interest rate movements between specified dates. They can provide considerable flexibility for managing interest rates, usually for a maximum of two years.
The forward market offers a company certainty.
6 Managing interest rate exposure
The yield measures the return on the investment. A number of different yields can be cal- culated:
● running yield:this compares the interest to the current price;
● gross redemption yield:this combines the interest with the capital gain on maturity to give a measure of the total return;
● net redemption yield:this is an after-tax measure of the total return;
● realised compound yield: this compounds the return by reflecting the fact that interest can be earned on interest.
SUMMARY
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Options
An option is just what it says, if the company buys an option it has the opportunity to buy something at an agreed price. Options can be bought and sold on shares, bonds, currencies, interest rates and futures contracts (a futures contract is a contract to buy or sell something at some agreed date in the future). Companies can buy, or sell, a cap(the maximum interest rate) or a floor(the minimum interest rate) over one or more periods. A cap suits borrowers, whereas a floor has an obvious appeal to lenders. These can be combined in a collar, which locks the company in a range of interest rates. When a company takes out an interest rate option it pays the market rate and is compensated when the rates are outside of the agreed level.
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Swaps
Both currency and interest rates can be ‘swapped’. Again, this means what it says. Interest- rate swaps exploit the credit quality standards between the fixed-rate bond market and the floating-rate, short-term credit market. These markets have different interest rates for differ- ent quality borrowers.
To illustrate this, a company rated BBB might be able to borrow short-term at LIBOR (London inter-bank offered rate) +3/4 per cent. Whereas a company rated AAA might borrow at LIBOR +
1⁄4per cent, a difference in the short-term markets of 1/2 per cent.
In the bond market, the interest rate differential widens considerably, the size of the differ- ence is determined by market conditions prevailing at the time, but it can be between 1 per cent and 2 per cent. We will assume that the AAA-rated company could issue a ten-year bond at 10 per cent, whereas the BBB-rated company would have to pay 111/4 per cent. With a bank as an intermediary they enter into a swap arrangement. The BBB-rated company raises short- term, variable-rate money and the AAA-fixed-rate money. They swap their interest, as is shown in Figure 6.4.
EXAMPLE
AN INTEREST RATE SWAP Figure 6.4
Issues bond @ 10% Borrows at LIBOR
Raises funds at LIBOR Raises funds at 11%
10%
Saves 1/4%
AAA- rated company
LIBOR + 3/4%
Saves 1/4%
BBB- rated company Gets 1/4%
BANK
10 1/4%
10%
LIBOR LIBOR
The AAA-rated company issues a fixed-rate bond at 10 per cent, and the BBB-rated company borrows at LIBOR + 3/4 per cent. Unfortunately this is not what they want; the AAA-rated com- pany wants variable rates (maybe it thinks that interest rates are going to fall) and the BBB-rated company wants fixed rates. The swap should work to both parties’ benefit.
The AAA-rated company gives the intermediary bank LIBOR; the bank then passes this on to the BBB-rated company. So, the BBB-rated company has received LIBOR from the AAA-rated company. The BBB-rated company then pays LIBOR +3/4 per cent on its loan, so it has to pay 3/4 per cent. It then gives the bank 10 1/4 per cent, the bank keeps 1/4 per cent for itself, and passes the 10 per cent to the AAA-rated company. The AAA-rated company can then pay its bondholders. The BBB-rated company’s borrowings end up costing 11 per cent, and it has locked itself into these rates for the long term. It has managed to get fixed-rate money via the swap, 1/4 per cent cheaper than it could get direct. It has what it wants. The AAA-rated company has switched out of fixed rates into variable rates and effectively borrowed at LIBOR (a quarter of a per cent cheaper than it can normally get). The bank has made a profit.
Although everybody seems to win there are two risks in an interest-rate swap:
(1) counterparty failure
(2) adverse interest rate movements.
Whilst it is possible to ‘unwind’, (cancel) a swap, this is usually expensive. A number of companies discovered this when Britain left the ERM and interest rates fell. They had locked themselves into high-fixed rates of interest, and had to pay to get themselves out of the swap.
Interest rate swaps are useful tools for company treasurers as they:
● allow companies to obtain long-term, fixed-rate money, which might not otherwise have access to the bond markets;
● reduce the cost of borrowing;
● allow companies to respond to changing economic conditions – moving from fixed to floating rates, without changing the underlying debt instrument.
6 Managing interest rate exposure
There are three main ways that companies manage their exposure to interest rates:
(1) forward rate agreements:the company locks itself into an agreed interest rate – what- ever happens to interest rates, this is the rate that the company will get. Forward rate agreements offer certainty;
(2) options:the company buys an option for an interest rate over one or more periods.
The option may be for a cap (the maximum interest rate), a floor (the minimum interest rate), or a collar, which locks the company in a range of interest rates.
Options offer flexibility because, if the market offers a better rate; the company does not have to take the option;
(3) swaps:these allow companies to move from fixed interest rates, or vice versa, by swap- ping their interest payments with another company. They exploit the credit quality standards between the fixed-rate bond market and the floating rate, short-term credit market. The spread between different quality borrowers is larger in the long-term, fixed-rate market than in the short-term market.
SUMMARY