Question

Organisations are faced with many risks, which include many types of economic risks, among them interest rate risks. Based on the above background

1. Describe and discuss the different types of interest risk
2. Describe the characteristics and benefits of interest rate swaps compared with other forms of interest rate risk management, such as forward rate agreements and interest rate futures

Answer 1

Interest rate risk:

Interest rate risk is also known as market risk. This risk is associated with fixed income securities (Like bonds). The risk is caused due to increase or decrease in the interest rates of the securities. For example if an investor is having a bond of $400 carrying an interest rate of 4%, when the interest rate raises to 5% the investor is supposed to get higher value for the bond. But the other investors usually prefer to go for newly issued bonds because they will having higher coupon rate, due to which the investor end up selling it for lower price. Similarly, In case of decrease in interest rate the investor has to sell it for fixed rate of return which cause him loss. This risk can be overcome by diversifying portfolio for the bonds having different maturity periods.

Types of Interest rate risks:

1. Equity risk : A potential loss caused due to adverse change in the prices of the stock. Every stock carries ownership interest in the companies. One company can purchase ownership in other companies and exposing them to the risk of changing the value of the share.
2. Foreign exchange risk : Banks buy and sell foreign currency on behalf of their customers to do their international transactions. And fluctuation in currency exchange rate may leads to change in the value of their assets and liabilities.
3. Commodity risk : There are different types of commodities like Agricultural commodities, Industrial commodities and energy commodities. This may cause potential risk due to adverse change in the prices of the commodities, which is caused by the change in the demand and supply for that commodity.
4. Operational risk : This risk is caused due to the failure of internal process, systems and people management or any other external events. which caused effect on the operations of the organization.

Interest rate swaps:

Interest rate swaps are the forward contracts where two parties enter into an agreement and exchange one stream of interest rate with another based on a specified principle amount. Usually fixed interest rate swaps are exchanged with the floating interest rate swaps and vice-versa to gain marginally lower interest rates.

For example : Company A requires $50 million for a project. In U.S they can borrow it for 4.5% and in outside they can get it for 4% interest rate. Now company A need to issue a bond in foreign currency which is subjected to fluctuations of home country's interest rates. Here company A needs to pay 4% interest to the counterpart over the period of the bond and the company would swap $50 million for the agreed exchange rate on the maturity of the bond by avoiding exposures to exchange rate changes.

Forward rate agreements are the cash settled contracts which takes place OTC between the two parties. In this contracts no amount will be exchanged but the notional amount is used to calculate the interest amount at a specified time period. The buyer of the FRA will be protected against the rise in interest rate and the seller of the FRA will be protected against the fall in the interest rate.

Interest rate futures are the future contracts in which two parties enter into contracts for an instrument which pays interest. The buyer and seller agrees to future delivery of interest bearing asset on the agreed future date. Both the parties will enter into contract at a specific lockdown price which will be paid on the future date.