Demystifying Derivatives–Clarifying Interest Rate Risk Management

Introduction to Interest Rate Hedging
The term “interest rate derivatives” often elicits uncertainty, even among seasoned corporate finance teams. Similar to other risk management instruments, many perceive these tools as complex.

However, because interest rates remain volatile, impacting borrowing costs, businesses managing variable-rate loans or planning major capital expenditures must now prioritise these tools more than ever.

This article seeks to clarify Interest Rate Swaps and Options (Caps, Floors, and Collars) and emphasise their practical applications for businesses. Rather than serving as a technical manual, it urges action, highlighting that fluctuations in interest rates can cause unforeseen cost increases, whereas hedging instruments offer a measure of certainty and financial stability.

The global economic landscape has seen significant shifts in interest rates in recent years, often catching businesses unprepared. For instance, in 2022, central banks rapidly raised rates to counter inflation, leaving companies with floating-rate loans facing unexpectedly higher interest payments. These sudden cost surges can strain profitability, especially for businesses reliant on debt financing.

This article will also highlight the potential risks of unhedged interest rate exposures and discuss how Interest Rate Swaps and Options can act as essential insurance against rate fluctuations, allowing businesses to focus on their growth objectives without fearing unpredictable borrowing costs.

How Does Interest Rate Risk Affect Corporates?

Consider a company that has taken a floating-rate loan tied to the Secured Overnight Financing Rate (SOFR) plus a margin of 3%. Paying at a floating rate means the future SOFR rate is unknown, which could be higher or lower than current levels, potentially burdening the client if SOFR rises. To illustrate, assume SOFR stands at 5%, the effective borrowing rate is thus 8%.

If SOFR increases by just 2% to 7%, the borrowing cost rises to 10%, potentially impacting profit margins significantly. For a loan of $10 million, this translates to an additional annual cost of $200,000 in interest alone. Without a hedging strategy, the business absorbs this increased cost, which they could have mitigated with the right risk management tools.

Similarly, businesses planning to issue fixed-rate bonds might find themselves disadvantaged if rates decrease after issuance, leaving them locked into higher costs.

What Precautions Can Businesses Take to Manage Interest Rate Risk?

Certainty is the key to mitigating interest rate risk.

By employing hedging tools like swaps, caps, floors, and collars, businesses can stabilise their borrowing costs, ensuring predictable cash flows. Let’s explore these tools:

(I) Interest Rate Swaps (IRS)

An Interest Rate Swap allows a business to exchange its floating interest payments for fixed payments (or vice versa). This tool is ideal for corporates with floating-rate loans who seek protection against rising interest rates.

Let us look at an example: Imagine the same company with a $10 million floating-rate loan at SOFR 3%. To hedge against potential rate increases, the company enters into an IRS agreement with the bank, locking in a fixed rate of 7% for the next three years.

• If SOFR rises to 8%, the company’s effective floating rate would have been 11%. However, under the IRS, the business continues paying the fixed rate of 7%, saving 4% annually on the loan.

• Conversely, if SOFR drops to 3%, the company still pays 7%. This creates a dilemma: paying more with fixed cash flows versus potentially paying less if the floating rate remains unchanged. This “cost” is, however, the trade-off for stability and predictability in financial planning.

Recommendation: Interest Rate Swaps are best suited for businesses with long-term floating-rate exposures. While they eliminate increasing interest rate risk, the trade-off is forfeiting potential savings if rates decline. The predominant impetus behind entering into such a swap arrangement is to therefore to enhance cash flow management or to pre-emptively mitigate the adverse effects expected from fluctuations in interest rates.

(II) Interest Rate Caps

A Cap provides the right to limit the maximum interest rate on a floating-rate loan. Businesses can benefit from lower rates while avoiding excessive increases.

Let us look at an example: Assume the company buys a Cap at 9% for its $10 million loan. If SOFR rises to 10%, the Cap activates, and the company pays a maximum of 9%. If rates remain below 9%, the business benefits from the lower floating rates.

There is, however, a cost to these structures given their immense benefit. They require an upfront premium, typically a percentage of the notional amount, which varies based on market volatility.

Recommendation: Caps are ideal for businesses expecting moderate rate increases but wanting to retain flexibility in case rates decrease.

(III) Interest Rate Floors (For Businesses that have investments)

A Floor sets a minimum interest rate level, ensuring a business earns a guaranteed return on interest-bearing assets like fixed deposits or bonds. If a company has invested in floating-rate instruments, a Floor ensures returns do not fall below a specified level, say 4%, even if SOFR drops to 2%. This is ideal for businesses or investment firms that want to protect their investment returns from declining and adversely impacting commitments made with the expectation of higher floating rates.

Recommendation: Floors are suitable for corporates with substantial interest-bearing assets exposed to declining rate environments.

(IV) Interest Rate Collars

A Collar combines a Cap and a Floor, creating a range within which the interest rate fluctuates. While it limits upside and downside risks, it usually comes with zero upfront premium.

We can look at an example of the same loan where the company enters into a Collar with a Cap of 9% and a Floor of 5%. If rates rise above 9%, the Cap ensures payments are capped at 9%. If rates drop below 5%, the Floor ensures payments remain at 5% essentially allowing the loan repayments to float in between the Cap and the Floor that is convenient for the business.

Recommendation: Collars work well for businesses looking to balance cost-effectiveness with risk protection, as they eliminate premium costs associated with standalone Caps or Floors.

Advantages of Hedging with Interest Rate Derivatives

There are many advantages of risk management products referencing interest rates:

1. Predictability: Ability to stabilise cash flows and enhance financial planning.

2. Flexibility: Options (Caps, Floors, and Collars) allow businesses to benefit from favourable market conditions.

3. Cost Savings: Swaps and zero-premium structures like Collars minimise hedging costs.

4. Competitive Edge: Protecting against rate volatility ensures businesses remain focused on operations without surprises from rate movements.

In an unpredictable interest rate environment, businesses must not leave their borrowing costs to chance. Utilising financial instruments such as Interest Rate Swaps, Caps, Floors, and Collars allows companies to mitigate the financial impact of rate fluctuations, ensuring stability in their operations.

We recommend discussing tailored solutions with your bank that align with your specific risk-reward profile. While the article primarily discussed SOFR hedging, it is important to note that Ghana Reference Rate (GRR) hedging is also feasible. This involves hedging where the local currency is utilized as either an asset or a liability. At Absa Bank, we are committed to guiding you in developing a comprehensive risk management strategy that supports your growth objectives while protecting your financial bottom line.

By Gerald Nana Kusi, Head Institutional Sales and Structuring, Absa Bank Ghana LTD

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