Interest rate risk exists in an interest-bearing asset, such as a loan or a bond, due to the possibility of a change in the asset's value resulting from the variability of interest rates. Interest rate 澳洲幸运5官方开奖结果体彩网:risk management has become very important, and assorted instruments have been developed to deal with 澳洲幸运5官方开奖结果体彩网:interest rate risk.

This article looks at several ways that both businesses and consumers manage interest rate risk using various interest rate 澳洲幸运5官方开奖结果体彩网:derivative instruments.

Which Investors Are Susceptible to💃 🅘Interest Rate Risk?

Interest rate risk is the risk that arises when the absolute level of interest rates fluctuates. Interest rate risk directly affects the values of fixed-income securities. Since 澳洲幸运5官方开奖结果体彩网:interest rates and bond prices are inversely related, the risk associated with a rise in interest rates causes bond prices to fall, and vice versa. Bond investors, specifically those who invest in long-term fixed-rate bonds, are more directly susceptible to interest rate risk.

Suppose an individual purchases a 3% fixed-rate 30-year bond for $10,000. This bond pays $300 per year through maturity. If during this time, interest rates rise to 3.5%, new bonds issued pay $350 per year through maturity, assuming a $10,000 investment. If the 3% bondholder conti♛nues to hold their bond thrꦑough maturity, they lose out on the opportunity to earn a higher interest rate.

Alternatively, they could sell their 3% bond in the market and buy the bond with the higher interest rate; however, doing so results in the investor getting a lower priceღ on their sale of 3% bonds as they are no lo🏅nger as attractive to investors since the newly issued 3.5% bonds are also available.

In contrast, changes in interest rates also affect equity investors but less directly than bond investors. This is because, for example, when interest rates rise, the corporation's cost of borrowing money also increases.

This could result in the corporation postponing borrowing, whi♓ch may result in less spending. This decrease in spending may slow down corporate growth and result in decreased profit and ultimately lower stock prices for investors.

Interest Rate Risk Should Not Be Ignored

As with any 澳洲幸运5官方开奖结果体彩网:risk-management assessment, there is always the option to do nothing, and that is what many people do; however, in circumstances of unpredictability, sometimes not hedging is disastrous. Yes, there is a c💦ost to hedging✃, but what is the cost of a major move in the wrong direction?

One need only look to Orange County, California, in 1994 to see evidence of the pitfalls of ignoring the threat of interest rate risk. In a nutshell, Orange County Treasurer Robert Citron borrowed money at lower short-term rates and lent money at higher long-term rates. The strategy was initially great as short-term rates fell and the 澳洲幸运5官方开奖结果体彩网:normal yield curve was maintained.

But when the curve began to turn and approach 澳洲幸运5官方开奖结果体彩网:inverted yield curve status, things changed. Losses to Orange County and the almost 200 public entities for which Citron managed money were estimated at nearly $1.7 billion and resulted in the municipality's 澳洲幸运5官方开奖结果体彩网:bankruptcy. That's a hefty price to pay for ignoring interest rate risk.

Investment Products

Those who want to hedge their investments against interest rate risk have many products to ꦚchoose from.

Forwards

A 澳洲幸运5官方开奖结果体彩网:forward contract is the most basic interest rate management product. The idea is simple, and many other products discusse🥀d in this arti🌟cle are based on this idea of an agreement today for an exchange of something at a specific future date.

Forward Rate Agreements (FRAs)

A 澳洲幸运5官方开奖结果体彩网:Forward Rate Agreement (FRA) is based on the idea of a forward contract, where the determinant of gain or loss is an interest rate. Under this agreement, one party pays a 澳洲幸运5官方开奖结果体彩网:fixed interest rate and receives a 澳洲幸运5官方开奖结果体彩网:floating interest rate equal to a 澳洲幸运5官方开奖结果体彩网:reference rate. The actual payments are calculated based on a 澳洲幸运5官方开奖结果体彩网:notional principal amount and paid at intervals determined by the parties. Only a net payment is made—the loser pays the winner, so to speak. FRAs are 🐓always settled in cash.

FRA users are typically borrowers or lenders with a single future date on which they are exposed to interest rate risk. A series of FRAs is similar to a swap (discussed below); however, in a swap, all payments are at the same rate. Each FRA in a series is priced at a different rate unless the 澳洲幸运5官方开奖结果体彩网:term structure is flat.

Futures

A 澳洲幸运5官方开奖结果体彩网:futures contract is similar to a forward, but it provides the counterparties with less risk than a forward contract—namely, a lessening of default and 澳洲幸运5官方开奖结果体彩网:liquidity risk due to the inclusion of an intermediary. 澳洲幸运5官方开奖结果体彩网:Interest rate changes, dividends, and stor🌜age costs all affﷺect the price of futures.

Swaps

Just like it sounds, a swap is an exchange. More specifically, an 澳洲幸运5官方开奖结果体彩网:interest rate swap looks a lot like a combination of FRAs and involves an agreement between counterparties to exchange sets of future cash flows. The most common type of interest rate swap is a 澳洲幸运5官方开奖结果体彩网:plain vanilla swജap, ꩵwhich involves one party paying a fixed interest rate and receiving a floating rate, and the other party paying a floating rate and receiving a fixed rate.

Options

Interest rate management options are option contracts for which the underlying security is a debt obligation. These instruments are useful in protecting the parties involved in a floating-rate loan, such as 澳洲幸运5官方开奖结果体彩网:adjustable-rate mortgages (ARMs). A grouping of interest rate call options is referred to as an interest rate cap; a combination of interest rate put options🌞 is referred to as an interest rate floor. In general, a cap is like a call, and a floor is like a put.

Swaptions

A swaption, or swap option, is si🌠mply an option to enter into a swap.

Embedded Options

Many investors encounter interest management derivative instruments via 澳洲幸运5官方开奖结果体彩网:embedded options. If you have ever bought a bond with a 澳洲幸运5官方开奖结果体彩网:call provision, you too are in the club. The issuer of your 澳洲幸运5官方开奖结果体彩网:callable bond is insuring that if interest rates decline, they can call in your bond and issue new bonds with a lower coupon.

Caps

A cap, also called a ceiling, is a call option on an interest rate. An example of its application would be a borrower going long, or paying a premium to buy a cap and receiving cashꦯ payments from the cap seller (the short) when the reference interest rate exceeds the cap's strike rate. The payments are designed to offset interest rate increases on a floating-rate loan.

If the actual interest rate exceeds the strike rate, the seller pays the difference between the strike and the interest rate multiplied by the notional principal. This option will "cap," or place an upper limit, on the holder's 澳洲幸运5官方开奖结果体彩网:interest expense.

The 澳洲幸运5官方开奖结果体彩网:interest rate cap is a series of component options, or "caplets," for each period the cap agreement exists. A caplet is designed to provide a hedge against a rise in the 澳洲幸运5官方开奖结果体彩网:benchmark interest rate, such as🎐 the Secured Overnight Financing🐼 Rate (SOFR), for a stated period.

Floors

Just as a put option is considered the mirror image of a call option, the floor is the mirror image of the cap. The 澳洲幸运5官方开奖结果体彩网:interest rate floor, like the cap, is a series of component options, except that they are put options and the series components are referred to as "floorlets." Whoever is long, the floor is paid upon maturity of the floorlets if the reference rate is below the floor's 澳洲幸运5官方开奖结果体彩网:strike price. A lender us🧸es this to protect against falling rates on an outstanding floating-rate loan.

Collars

A protective 澳洲幸运5官方开奖结果体彩网:interest rate collar can also help manage interest rate risk. Collaring is accomplished by simultaneously buying a cap and selling a floor (or vice versa), just like 澳洲幸运5官方开奖结果体彩网:a collar protects an investor who is long on a stock. A 澳洲幸运5官方开奖结果体彩网:zero-cost collar can also be 🍌established to lower the cost of hedging, but this lessens the potential profit that would be enjoyed by an interest rate 🐲;movement in your favor as you have placed a ceiling on your potential profit.

The Bottom Line

Each of the products discussed above provides a way to hedge interest rate risk, with different products more appropriate for different scenarios. There is, however, no 澳洲幸运5官方开奖结果体彩网:free lunch. With any of these alternatives, one gives up something: either money, like premiums paid for options, or 澳洲幸运5官方开奖结果体彩网:opportunity cost, which is the profit one♎ would h☂ave made without hedging.