Interest Rate Risk Hedging

Interest rate risk affects different assets/liabilities in different ways and the hedging needs of a situation differ based on the objective of hedging. There are two primary ways interest rate variability affects an entity and hence two different approaches to hedging are generally required.

The first case is where an asset or liability (such as a loan or a deposit) has a variable interest rate benchmark based payments and hence hedging objective is to ensure that the variable rates are moved into fixed rates.

The second scenario is when the asset or liability on the balance sheet is a market instrument (such as bond, debenture etc.), whose price changes as per market interest rates (typically fixed rate instruments). In such cases, the hedging objective is to minimize the price variability by converting the fixed rate asset/liability to a floating rate one.

Various hedging instruments are available in markets to manage interest rate exposure. Most of the interest rate derivatives are usually traded over-the-counter (OTC), and offered primarily by banks. We discuss two instruments here – Interest rate swaps (IRS) and Interest rate caps.

The discussion is primarily focused on the uses of these instruments for hedging the floating rate cash flow variability.

Interest Rate Swap is a product wherein two parties enter into a contract to exchange a series of payments at fixed intervals. One receives/pays fixed interest on the notional amount and another receives/pays variable interest rate. The payments are netted and the structure can be customized as it is  an over the counter product.

Typically the floating side of a swap is based on a standard benchmark available in that currency. For instance, in USD markets, the floating rate benchmark is based on the SOFR rate (earlier used to be Libor based). To hedge a loan based on SOFR, the counterparty pays a fixed rate to the bank and receives the floating benchmark used for servicing the loan.

Any swap contract specifies the following:

1. Notional of the transaction on which the interest payments occur
2. Tenor of the swap
3. The benchmark used
4. The fixed rate
5. The day count convention
6. And the frequency of payments

The fixed rate of the swap for a given tenor is traded in the market directly and is called the IRS rate. The market trades the IRS rates for different tenors. In USD market, the traded standard tenors are: annually up to 10y, 12y, 15y, 20y, 25y and 30y. Any other tenor can be priced by appropriate interpolations. Similarly complicated swaps which have amortizing notional are priced using a pricing process which involves aspects such as bootstrapping.

Swap rates for different tenors constitute what is called a swap curve. This swap is bootstrapped first to arrive at the Discount Factors (or the zero rates) and any non-standard swap can be priced using these Discount Factors. The swap pricing is a fairly involved process and needs a software to capture all the nuances.

Interest rate swaps involve counterparty risk of default and hence has an embedded credit risk. Counterparties need to have appropriate credit lines to ensure that this exposure is measured and accounted for.

IRS market is very large and is liquid in various currencies. For USD, SOFR based swaps dominate. In EUR markets, ESTR and Euribor swaps are traded, and TONA based swaps are the mainstay in the Japanese markets. In Indian markets, Mibor based Overnight swaps and MIFOR based swaps are the important swaps for hedging.

Interest Rate Caps

Since the IRS transaction locks in a floating rate into fixed rate, it does not leave any upside to the hedger in cases interest rates fall. Instead, if the entity wants an instrument which can leave the upside of future interest rate fall open, then an option on interest rate is appropriate.

Interest Rate Cap is an option on the benchmark interest. As the name suggests, the cap ensures that the future rates never cross a cap level (also called strike rate) and in case the benchmark is higher than that level, the buyer of the cap is compensated the difference. For example a SOFR cap at 4% means that if future SOFR rate is higher than 4%, say 4.25%, the 0.25% p.a. difference is compensated to the borrower by the bank. The effect of the Cap is that the maximum rate payable by the borrower gets capped at the strike and hence the name.

As with a swap, a Cap also is specified using Notional, tenor, benchmark, frequency and additionally the strike rate (cap rate). The pricing of a Cap is dependent not only on the swap rates, but also on expected interest rate volatility and is done using the Black Formula.

Caps can be tailor made by balancing the cost of the Cap with the strike rate level to suit one’s hedging needs.

Conclusion

Interest rate hedging, in the current rate environment, has to be undertaken carefully as long-term trends in rates tend to be very volatile in times of aggressive central bank action. Hedging using swaps and/or caps must be evaluated by looking at the need for hedging, tenor of hedging, market view over a long time, risk appetite and cost dynamics. Both swaps and caps have their uses and have to be used judiciously and optimally to ensure long-term protection at a minimal cost.

QuantArt

At QuantArt, we help various companies manage their risks by advising on timing of hedges, tenor of hedges and the appropriate hedge instruments suitable to the interest rate view. In addition to plain vanilla swaps, we evaluate alternatives such as cap and other complex structures such as collars, cap spreads and even exotics such as Range Accruals etc. to ensure that clients are hedged when needed, but are not stuck in a high interest rate hedge when market rate cycle turns.

You can reach out to us at advisor@quantartmarket.com for any queries on this topic.