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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.

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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 three per cent. 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 five per cent the effective borrowing rate is thus eight per cent.

If SOFR increases by just two per cent to seven per cent the borrowing cost rises to 10 per cent, 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 + three per cent. To hedge against potential rate increases, the com­pany enters into an IRS agreement with the bank, locking in a fixed rate of seven per cent for the next three years.

• If SOFR rises to eight per cent, the company’s effective floating rate would have been 11 per cent. However, under the IRS, the business continues paying the fixed rate of seven per cent, saving four per cent annually on the loan.

• Conversely, if SOFR drops to three per cent, the compa­ny still pays seven per cent. 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 nine per cent for its $10 million loan. If SOFR rises to 10 per cent, the Cap activates, and the company pays a maximum of nine per cent. If rates remain below nine per cent, 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 four per cent, even if SOFR drops to two per cent. 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 nine per cent and a Floor of five per cent. If rates rise above nine per cent, the Cap ensures payments are capped at nine per cent. If rates drop below five per cent, the Floor ensures payments remain at five per cent 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 utilised 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

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