Interest Rate Risk and Derivatives
International
Interest Rate Risk and Derivatives
Syllabus tag: KASNEB CPA | Advanced Level | CA33 Advanced Financial Management | Topic 9 Interest Rate Risk and Derivatives
Lesson objectives
By the end of this topic, you will be able to:
- Identify the sources of interest rate exposure
- Construct and settle a forward rate agreement
- Explain interest rate futures, options, caps, floors and collars
- Compute the gain available from an interest rate swap
- Select an instrument for a given exposure
Why this matters
A company borrowing at a floating rate does not know what its interest bill will be. The instruments here convert that uncertainty into a known figure — or cap it — and the arithmetic of who benefits is examinable.
Sources of exposure
Borrowing at a floating rate — the cost rises with the market. Borrowing at a fixed rate — no cash risk, but an opportunity loss if rates fall. A planned future borrowing — rates may rise before the loan is taken out. Investing at a floating rate — income falls when rates fall.
Note that fixed-rate borrowing does not remove the exposure; it converts a cash flow risk into an opportunity cost. Neither position is risk-free.
Forward rate agreements
An FRA fixes the interest rate on a notional amount for a future period. No principal changes hands: the parties settle the difference between the agreed rate and the actual rate.
A company will borrow KES 200,000,000 for six months, starting in three months. It buys a 3v9 FRA at 11.40%.
If the rate rises to 13.2%:
| KES | |
|---|---|
| Interest actually paid (200m × 13.2% × ½) | 13,200,000 |
| Compensation received under the FRA | (1,800,000) |
| Net cost | 11,400,000 |
If the rate falls to 9.6%:
| KES | |
|---|---|
| Interest actually paid (200m × 9.6% × ½) | 9,600,000 |
| Payment made under the FRA | 1,800,000 |
| Net cost | 11,400,000 |
The cost is 11,400,000 either way. That is what a hedge does — and it is worth being explicit that the company gives up the benefit of a favourable move as the price of certainty. An FRA is not a bet on rates; it removes the bet.
:::checkpoint A treasurer refuses to hedge, saying rates are more likely to fall than rise. Explain what they are actually doing with the company's money and under what circumstances the position might be defensible. :::
Interest rate futures
Exchange-traded and standardised in amount and date, so they rarely match an exposure exactly. Two consequences:
- Basis risk — the futures price and the cash market price do not move perfectly together
- Margin must be posted and topped up as prices move
Futures prices are quoted as 100 minus the interest rate, so a rise in rates means a fall in the futures price. A borrower fearing a rate rise therefore sells futures now and buys them back cheaper later.
Options, caps, floors and collars
An interest rate option gives the right, not the obligation, to borrow or lend at a set rate. The premium is paid whether or not it is exercised.
A cap sets a maximum borrowing rate. On KES 150,000,000 for six months with a cap at 13%, if the rate reaches 15% the compensation is:
150,000,000 × (15% − 13%) × ½ = KES 1,500,000
A floor sets a minimum rate, protecting a depositor.
A collar combines the two: buy a cap and sell a floor. The premium received on the floor reduces the net cost of the cap — and the company gives up the benefit of rates falling below the floor.
The collar is the practical compromise. A cap alone is expensive; a swap removes all flexibility; a collar fixes a range at modest cost.
Interest rate swaps
Two parties exchange interest obligations, usually fixed for floating. The principal is notional and is never exchanged.
The gain arises from comparative advantage.
| Fixed | Floating | |
|---|---|---|
| Company A | 12% | LIBOR + 1% |
| Company B | 14% | LIBOR + 2% |
A borrows more cheaply on both measures. But look at the size of the advantage:
- Fixed: A is better by 2%
- Floating: A is better by 1%
Total gain available = 2% − 1% = 1%, to be shared between them.
A has the greater advantage in the fixed market, so A borrows fixed and B borrows floating, and they swap. Split evenly, each saves 0.5%.
The principle is exactly Ricardo's comparative advantage from the Economics paper: each party borrows where its relative advantage is greatest, not where it is absolutely cheapest.
Other reasons to swap: to change the interest profile without renegotiating the underlying loan, to match assets and liabilities, and to access a market the company could not borrow in directly.
The risks: counterparty default, and the fact that the swap is a binding commitment — a company that swaps to fixed and then sees rates fall is locked in.
Choosing an instrument
| Situation | Instrument |
|---|---|
| A single known future borrowing | FRA |
| A standard amount and date, liquidity wanted | Futures |
| Exposure uncertain, or upside wanted | Option or cap |
| Cheaper protection, some upside given up | Collar |
| Long-term change to the interest profile | Swap |
The pattern mirrors currency hedging: an obligation for a certain exposure, an option for an uncertain one, and a swap where the requirement is structural rather than one-off.
:::checkpoint Two companies face the fixed and floating rates in the table above. Show which market each should borrow in, and compute the rate each ends up paying if the 1% gain is split evenly and there are no intermediary fees. :::