INSTRUCTIONAL MATERIAL

Treasury Management
(FIMA 40103)

WEEK 6-7
INTEREST RATE RISK MANAGEMENT

Objectives:

 Identify and implement appropriate strategies to manage interest rate risks

 Demonstrate the application of techniques used in interest rate risk management

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 risk management has become very important, and assorted instruments have been
developed to deal with interest rate risk.

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 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
continues to hold his bond through maturity, he loses out on the opportunity to earn a higher
interest rate.

Alternatively, he could sell his 3% bond in the market and buy the bond with the higher
interest rate. However, doing so results in the investor getting a lower price on his sale of 3%
bonds as they are no longer 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
Daren D. Cortez, CFMP, CATP, MBA
Department of Financial Management
College of Accountancy and Finance
Polytechnic University of the Philippines
 INSTRUCTIONAL MATERIAL
Treasury Management
(FIMA 40103)

borrowing money also increases. This could result in the corporation postponing borrowing, which
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 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 cost 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 normal yield curve was maintained. But when
the curve began to turn and approach 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 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 choose from:

Forwards: A forward contract is the most basic interest rate management product. The
idea is simple, and many other products discussed in this article are based on this idea of an
agreement today for an exchange of something at a specific future date.

Forward Rate Agreements (FRAs): An 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
fixed interest rate and receives a floating interest rate equal to a reference rate. The actual
payments are calculated based on a 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.

Daren D. Cortez, CFMP, CATP, MBA

Department of Financial Management
College of Accountancy and Finance
Polytechnic University of the Philippines
 INSTRUCTIONAL MATERIAL
Treasury Management
(FIMA 40103)

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 term structure is flat.

Futures: A 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 liquidity risk due to the
inclusion of an intermediary.

Swaps: Just like it sounds, a swap is an exchange. More specifically, an 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 plain vanilla
swap, which 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 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 simply an option to enter into a swap.

Embedded options: Many investors encounter interest management derivative

instruments via embedded options. If you have ever bought a bond with a call provision, you too
are in the club. The issuer of your 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 cash
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 interest expense.

Daren D. Cortez, CFMP, CATP, MBA

Department of Financial Management
College of Accountancy and Finance
Polytechnic University of the Philippines
 INSTRUCTIONAL MATERIAL
Treasury Management
(FIMA 40103)

The 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 benchmark
interest rate, such as the London Interbank Offered Rate (LIBOR), 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 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 strike
price. A lender uses this to protect against falling rates on an outstanding floating-rate loan.

Collars: A protective 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 a collar
protects an investor who is long on a stock. A 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.

INTEREST RATE PARITY

The interest rate parity (IRP) is a theory regarding the relationship between the spot
exchange rate and the expected spot rate or forward exchange rate of two currencies, based on
interest rates. The theory holds that the forward exchange rate should be equal to the spot
currency exchange rate times the interest rate of the home country, divided by the interest rate of
the foreign country.

As with many other theories, the equation can be rearranged to solve for any single
component of the equation to draw different inferences. If IRP holds true, then you should not be
able to create a profit simply by borrowing money, exchanging it into a foreign currency, and
exchanging it back to your home currency at a later date.

Interpreting the Interest Rate Parity (IRP) Theory

The below diagram showcases the interest rate parity relationship. If you were to start at
any corner, then you can see how the exchange rates and interest rates should hold so that it is
not possible to profit, assuming currencies are in equilibrium. Starting from the top left corner, if
you were to borrow money at your home interest rate, we can see what would happen if we were

Daren D. Cortez, CFMP, CATP, MBA

Department of Financial Management
College of Accountancy and Finance
Polytechnic University of the Philippines
 INSTRUCTIONAL MATERIAL
Treasury Management
(FIMA 40103)

to exchange this money at the spot rate, invest at the foreign interest rate, and then exchange
money back into the home currency.

According to the IRP relationship, the

amount that you have exchanged at the spot
rate, invested in the foreign interest rate and
then exchanged at the future date should be
equal to simply investing in the home currency
interest rate for the same period of time. The
idea behind the IRP theory is that if currencies
are in equilibrium, then you should not be able to
profit from just exchanging money.

Uncovered Interest Rate Parity vs Covered Interest Rate Parity

The uncovered and covered interest rate parities are very similar. The difference is that
the uncovered IRP refers to the state in which no-arbitrage is satisfied without the use of a forward
contract. In the uncovered IRP, the expected exchange rate adjusts so that IRP holds. This
concept is a part of the expected spot exchange rate determination.

The covered interest rate parity refers to the state in which no-arbitrage is satisfied with
the use of a forward contract. In the covered IRP, investors would be indifferent as to whether to
invest in their home country interest rate or the foreign country interest rate since the forward
exchange rate is holding the currencies in equilibrium. This concept is part of the forward
exchange rate determination.

Interest Rate Parity Equation

The covered and uncovered IRP equations are very similar, with the only difference being
the substitution of the forward exchange rate for the expected spot exchange rate. The following
shows the equation for the uncovered interest rate parity:

The following is the equation for the covered interest rate parity:

Daren D. Cortez, CFMP, CATP, MBA

Department of Financial Management
College of Accountancy and Finance
Polytechnic University of the Philippines
 INSTRUCTIONAL MATERIAL
Treasury Management
(FIMA 40103)

Interest rate parity is also often shown in the form that isolates the interest rate of the
home country:

For all forms of the equation:

St(a/b) = The Spot Rate (In Currency A Per Currency B)

ST(a/b) = Expected Spot Rate at time T (In Currency A Per Currency B)
Ft(a/b) = The Forward Rate (In Currency A Per Currency B)
ia = Interest Rate of Country A
ib = Interest Rate of Country B
T = Time to Expiration Date

Daren D. Cortez, CFMP, CATP, MBA

Department of Financial Management
College of Accountancy and Finance
Polytechnic University of the Philippines
 INSTRUCTIONAL MATERIAL
Treasury Management
(FIMA 40103)

Activities/ Assessment:

Parity Relationships

Problem 1: For the last seven months, 𝑟$ = 1.77% and 𝑟𝑃 = 0.75%. What would be the
appropriate expression for the interest rate parity relationship?

Problem 2: Suppose that the current spot exchange rate is €1.50/₤ and the one-year
forward exchange rate is €1.60/₤. The one-year interest rate is 5.4% in euros and 5.2% in pounds.
You can borrow at most €1,000,000 or the equivalent pound amount, i.e., ₤666,667, at the current
spot exchange rate. Show how you can realize a guaranteed profit from covered interest
arbitrage. Assume that you are a euro-based investor. Also determine the size of the arbitrage
profit.

Problem 3: Suppose that the treasurer of IBM has an extra cash reserve of $100,000,000
to invest for six months. The six-month interest rate is 8 percent per annum in the United States
and 7 percent per annum in Germany. Currently, the spot exchange rate is €1.01 per dollar and
the six-month forward exchange rate is €0.99 per dollar. The treasurer of IBM does not wish to
bear any exchange risk. Where should he/she invest to maximize the return?

Problem 4: Explain the conditions under which the forward exchange rate will be an
unbiased predictor of the future spot exchange rate.

Daren D. Cortez, CFMP, CATP, MBA

Department of Financial Management
College of Accountancy and Finance
Polytechnic University of the Philippines