Question

what factors would you consider when developing a swap strategy to manage interest rate risk

Answer 1

Factors which are considered when developing a swap strategy to manage interest rate risk are as follows:

1.Length of Loan Terms

One of the largest determinants of the interest rate risk a company is exposed to is its loan terms, on its borrowings and on the loans it issues. Even the majority of small businesses may face this problem if they offer terms to their customers. For example, if the business charges a fixed interest rate on its accounts receivable and short-term interest rates increase, it may find its bottom line dropping if it has to refinance its bank demand debt without any corresponding increases in what it charges customers. If interest rates on trade receivables is kept in sync with interest rates on a company's borrowings, the overall interest rate risk for the business is reduced.

2.Credit Risk

A company's credit risk is, in part, determined by its debt to equity ratio. As interest rates rise, equity falls because the company is paying out more interest. This increases the overall credit risk of the company, which, in turn, causes lenders to raise interest rates on new borrowings. The more debt exposure a company has, the higher its overall interest rate risk is.

3.Overall Economic Climate

The wider economic markets can have an impact on a company's interest rate risk. In times of economic decline or recession, a company can find refinancing and new borrowing more difficult and interest rates higher. This is often a time when revenues decline as fewer customers are financing purchases. The uncertainty of incoming cash flow coupled with the increased outgoing cash flow from interest payments increases the company's exposure to interest rate risk.

4.Foreign Exchange Rates

The strength of the U.S. dollar against other foreign currencies, such as the pound or the yen, can impact a company's interest rate risk if it is paying interest on foreign debt. For example, if a small clothing manufacturer is taking credit terms from its Chinese supplier in yuan, that debt becomes more expensive if the U.S. dollar weakens. The company's revenues are still coming in U.S. dollars but its debt is now a larger drag on the bottom line.