Corporate Finance

Lecture 10
Interest Rate risk
Sujana Shafique
Office: Rose Bowl 417
Email: [email protected]
 Objectives

 Describe and discuss “Basis risk: as a form of

interest rate risk
 Define the term structure of interest rates
 Explain the features of a yield curve
 Explain theories and their impacts on the yield
curve.
 Discuss and apply different methods of interest
rate risk management
 Define the main types of interest rate
derivatives and explain how they can be used to
hedge interest rate risk.
 Interest rate risk
Financial managers face risk arising from changes in interest rates, i.e.
a lack of certainty about the amounts or timings of cash payments and
receipts.
• There is some risk in deciding the balance or mix between floating
rate and fixed rate debt. Too much fixed-rate debt creates an
exposure to falling long-term interest rates and too much floating-
rate debt creates an exposure to a rise in short-term interest rates.
• In addition, companies face the risk that interest rates might change
between the point when the company identifies the need to borrow
or invest and the actual date when they enter into the transaction.
• Managers are normally risk-averse, so they will look for techniques
to manage and reduce these risks.
• Compared to currency exchange rates,
interest rates do not change continually:
• currency exchange rates change
throughout the day interest rates can be
stable for much longer periods

• But changes in interest rates can be

substantial.
 Gap exposure
• The degree to which a firm is exposed to interest rate risk can be
identified through gap analysis.
• This uses the principle of grouping together assets and liabilities that
are affected by interest rate changes according to their maturity
dates. Two different types of gap may occur:
• A negative gap occurs when interest-sensitive liabilities maturing at
a certain time are greater than interest-sensitive assets maturing at
the same time. This results in a net exposure if interest rates rise by
the time of maturity;
A positive gap occurs is the amount of interest-sensitive assets
maturing in a certain period exceeds the amount of
interest-sensitive liabilities maturing at the same time.
In this situation the firm will lose out if interest rates fall by maturity
Why interest rates fluctuate
• The term structure of interest rates refers to the way in
which the yield (return) of a debt security or bond varies
according to the term of the security, i.e. to the length of
time before the borrowing will be repaid.
• The yield curve is an analysis of the relationship between
the yields on debt with different periods to maturity. A
yield curve can have any shape, and can fluctuate up and
down for different maturities.
• The slope of the yield curve is also seen as important:
the greater the slope, the greater the gap
between short- and long-term rates.
 Types of yield curve shapes
• There are three main types of yield curve shapes:
normal, inverted and flat (or humped):
• Normal yield curve - “ longer maturity bonds have a
higher yield compared with shorter-term bonds due to
the risks associated with time.
• Inverted yield curve - “ the shorter-term yields are
higher than the longer-term yields, which can be a sign
of upcoming recession.
• Flat (or humped) yield curve - “ the shorter- and
longer-term yields are very close to each other,
which is also a predictor of an economic
transition.
(1) THE NORMAL YIELD CURVE

Longer term bonds have a higher yield than

shorter-term bonds due to the risks associated
with time. Although the curve slopes
upwards, the gradient is not steep. A normal
yield curve might be expected when interest
are not expected to change.
Normal yield curve
Normal YC

Yield

Term to maturity (years)

(2) INVERTED / INVERSE YIELD CURVE

This is downward sloping, meaning that the

shorter-term instruments have a higher yield
than the longer-term. An inverse yield curve
might be expected when interest rates are
currently high but are expected to fall. It may be
a sign of upcoming recession.
Inverted/Inverse yield curve

Inverted YC

Yield
(3) STEEP UPWARD-SLOPING CURVE

When interest rates are expected to rise, the

yield curve is likely to have a steep upward
slope, with yields on longer-term investments
much higher than the yield on shorter-dated
investment.
Steep Upward Sloping Curve

Yield

Term to maturity (years)

 Theories
• The shape of the yield curve at any point in time is the result of the
three following theories acting together:
• Liquidity preference theory
Investors have a natural preference for more liquid (shorter maturity)
investments. They will need to be compensated if they are deprived
of cash for a longer period.
• Expectations theory
The normal upward sloping yield curve reflects the expectation that
inflation levels, and therefore interest rates will increase in the future.
Market segmentation theory
• The market segmentation theory suggests that there are different
players in the short-term end of the market and the
long-term end of the market.
Liquidity preference theory
• Investors have a natural preference for holding cash
rather than other investments, even low-risk ones
such as government securities.
• They therefore need to be compensated with a higher
yield for being deprived of their cash for a longer
period of time.
• The normal shape of the curve as being upwards
sloping can be explained by liquidity preference
theory.
 Expectations theory
• This theory states that the shape of the yield curve varies
according to investors' expectations of future interest rates.
A curve that rises steeply from left to right indicates that
rates of interest are expected to rise in the future.
• A falling yield curve (also called an inverted curve, since it
represents the opposite of the usual situation) implies that
interest rates are expected to fall. .
• A flat yield curve indicates expectations that interest rates
are not expected to change materially in the future .
Market segmentation theory
• As a result of the market segmentation theory, the two ends of the
curve may have different shapes, as they are influenced
independently by different factors.
• The supply and demand forces in various segments of the market
in part influence the shape of the yield curve.
• Market segmentation theory explains the 'wiggle' seen in the
middle of the curve where the short end of the curve meets the
long end - “ it is a natural disturbance where two different curves
are joining and the influence of both the short-term factors are
weakest.
The significance of the yield curve
• Financial managers should inspect the current shape of the
yield curve when deciding on the term of borrowings or
deposits, since the curve encapsulates the market's
expectations of future movements in interest rates.
• For example, a normal upward sloping yield curve suggests
that interest rates will rise in the future. The manager may
therefore:
• wish to avoid borrowing long-term on variable rates, since the
interest charge may increase considerably over the term of the
loan choose short-term variable rate borrowing or long-term
fixed rate instead.
 Hedging interest rate risk:
Forward rate agreements (FRAs)
The aim of an FRA is to:
• Lock the company into a target interest rate
hedge both adverse and favourable interest rate movements.
• The company enters into a normal loan but independently
organises a forward rate agreement with a bank:
• Interest is paid on the loan in the normal way
if the interest is greater than the agreed forward rate, the bank
pays the difference to the company if the interest is less than
the agreed forward rate, the company pays the difference to
the bank.
 Hedging interest rate risk:
Interest rate guarantees (IRGs)
• An IRG is an option on an FRA. It allows the
company a period of time during which it has the
option to buy an FRA at a set price.
• IRGs, like all options, protect the company from
adverse movements and allow it to take advantage of
favourable movements.
• Decision rules:
 Hedging interest rate risk:
Interest rate futures
Interest rate futures work in much the same way as
currency futures.
The result of a future is to :
• Lock the company into the effective interest rate
• Hedge both adverse and favourable interest rate
movements.
Futures can be used to fix the rate on loans and
investments.
Basis risk
• The gain or loss on the future may not exactly offset the cash
effect of the change in interest rates, i.e. the hedge may be
imperfect. This is known as basis risk.
• The risk arises because the price of a futures contract may be
different from the spot price on a given date, and this
difference is the basis. This is caused by market forces. The
exception is on the expiry date, when the basis is zero.
• The other main reason why a hedge may be imperfect is
because the commodity being hedged (be it currency or
interest) must be rounded to a whole number of contacts,
causing inaccuracies.
 Hedging interest rate risk:
Options
• Borrowers may additionally buy options on
futures contracts. These allow them to enter
into the future if needed, but let it lapse if the
market rates move in their favour.
 Hedging interest rate risk:
Swaps
• An interest rate swap is an agreement whereby the
parties agree to swap a floating stream of interest
payments for a fixed stream of interest payments
and vice versa. There is no exchange of principal.
• Swaps can be used to hedge against an adverse
movement in interest rates. Swaps may also be
sought by firms that desire a type of interest rate
structure that another firm can provide less
expensively.
 Other practical ways to manage risk :
Cash flow matching
The concept of cash matching is to eliminate interest rate risk by
eliminating all net future cash flows.
• A portfolio is cash matched if :
• every future cash inflow is balanced with an offsetting cash
outflow on the same date every future cash outflow is balanced
with an offsetting cash inflow on the same date. The net cash flow
for every date in the future is then zero, and there is no risk of
interest rate exposure.
Whilst clearly not achievable, it does provide a broad goal that
businesses can work towards.
An effective, but largely impractical, means of
eliminating interest rate risk.
 Other practical ways to manage risk
Asset and liability management
• Asset and liability management

• Suppose a company is earning 6% on an asset supported by a

liability on which it is paying 4%. The asset matures in two years
while the liability matures in ten.

• Problems arise if interest rates are fixed on liabilities for periods

that differ from those on offsetting assets.
• To avoid this, companies attempt to match the duration of their
assets and liabilities.
 Objectives

 Describe and discuss “Basis risk: as a form of

interest rate risk Done!
 Define the term structure of interest rates Done!
 Explain the features of a yield curve Done!
 Explain theories and their impacts on the yield
curve. Done!
 Discuss and apply different methods of interest
rate risk management. Done!
 Define the main types of interest rate
derivatives and explain how they can be used to
hedge interest rate risk. Done!
Please Read around the topic from the recommended chapters
and attend the ask the tutor session if you have any question.

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