The world of FX markets and interest rate risk is a complex one. Once a business has taken on a foreign currency, either as a source of funds or as a source of the profit to be repatriated, there is an interest rate risk attached.
If you are considering taking on a foreign currency, whether a bank loan or a trade receivable, it is clearly worth having a look at the interest rate risks beforehand. The interest rate risk attached to a foreign currency can be just as important as the currency risk itself.
Understanding interest risks is crucial, especially if you want to appreciate the potential value of hedging and other FX risk management methods. There are different interest rate risks attached to different foreign currencies, which must be assessed and quantified.
The typical way of calculating interest rate risk is to use scenarios, but one of the things that every FX manager should ensure is that their scenarios are as realistic as possible.
The rate of interest on a loan or on a deposit can change at any time. This means that when a business makes a decision to enter into a foreign currency:
(i) at the same time, there is a decision to enter into a loan or to accept a deposit and
(ii) when that loan or deposit matures, the rate of interest, compared to the rate of interest at the time of entering into the loan or deposit, might be different.
It is easy to think that this is a simple calculation. Just take the interest rate payable on the loan or the deposit and compare it to the interest rate that you would have to pay on a loan in domestic currency to obtain a loan of approximately the same value.
The problem is that this is ignoring the fact that the value of the foreign currency might have moved as well. In fact, the problems of comparing interest rates is one of the reasons why the Bank for International Settlements have had to come up with their bank rate regime.
They have found that on a comparative basis, the comparison between domestic and foreign currency loans is not always simple. But that's where hedging comes into play!
The whole purpose of hedging is to ensure that rising interest rates are not a significant source of risk for your business. In other words, that you are hedging against the risk of rising interest rates.
This is achieved by using an interest rate swap to fix an interest rate for a certain period of time. An interest rate swap is a contract between two parties, which stipulates that the exchange of interest rates between the two parties on a predetermined date.
In other words, you pay the lower interest rate and receive the higher interest rate. If the interest rates of the two parties increase, the fixed rate is repaid and the floating rate is paid.
If the interest rates of the two parties decrease, the floating rate is repaid, and the fixed rate is paid. The advantage of this is that one party is effectively paying the risk off the other party. The party paying the interest rate risk off the other party is reaping a benefit in the form of a lower interest rate on the loan.
Hedging against the risk of rising interest rates is a simple process, but it is not a process that is quickly completed. The hedging process takes time to complete, so that can make for a complicated situation for any business.
The main complication is that US dollar interest rates might be low, but if the interest rates in your home currency are low, then it might seem more cost-effective to simply roll over a loan in your home currency than to enter into a risky interest rate swap.
When we talk about the basic approaches to interest rate risk management, we are essentially talking about two different approaches, known as matching and smoothing.
Matching is essentially the matching of the cash flows of the loan or deposit with the cash flows of the hedging instruments. This approach is not much different to simply rolling over a loan in one's home currency. The main difference is that the exchange rate is matched with the interest rate.
Smoothing is the smoothing of the cash flows of the loan or deposit with the cash flows of the hedging instruments, by offsetting the cash flows of the loan or deposit over time.
This means that the FX manager is essentially boosting the interest rate risk. In other words, they are boosting the interest rate risk of the business by offsetting the cash flows of the loan or deposit over time. That step is essentially an increase in the interest rate risk of a business.
These two approaches do not always fit hand in hand. In other words, one does not always result in the other. Matching is the amount of money that is borrowed or the amount of money that is paid, whereas smoothing is the strategy that is used to minimize the effect of interest rate volatility.
These approaches are both ideal for businesses that have to roll over loans or deposits. For example, if a business has a business line of credit, then it is clearly going to have to roll over this loan. The bank will give a maximum amount that can be borrowed and the business will borrow the maximum amount on that date.
Then, when the bank decides it is time to reduce the amount of credit they are giving the business, they will say that the maximum amount has been reached, and the business will have to pay off a certain amount.
The term, "asset and liability management" refers to the notion that a business is essentially managing its cash flow by investing its money in a way that matches its investment priorities.
The purpose of this strategy is to protect against the risk of rising interest rates by smoothing the cash flows of the loan. In other words, if a business has a line of credit, then there is a risk of currency fluctuation and a risk of rising interest rates.
This approach is commonly known as the asset-liability management approach. The simplest way to explain this is that by smoothing the cash flows of the loan or deposit, the business is making a strategic adjustment to attract as much cash as possible, while paying as little as possible.
This is a complicated strategy that can be difficult to implement, but it can lead to lower interest rates and higher net earnings.
The main benefit of this approach is that it is self-financing, in terms of interest rate volatility. In other words, the whole process is a long term strategy that is actually based on the principle of matching and smoothing.
The other main approach to interest rate risk is the forward rate agreement approach. An FRA is an agreement between a buyer and a seller to exchange floating and fixed interest rates at a predetermined date. That date is usually the maturity date on a loan or deposit.
The whole point of an FRA is that the fixed interest rate is used to hedge the cost of the loan. An FRA is the simplest way of hedging against rising interest rates.
When you open an FRA, you are effectively entering into a contract to fix the cost of borrowing or the cost of the loan. You are also entering into a contract to fix your future interest costs. In other words, you are entering into a forward rate agreement to fix your interest rate.
The beauty of this approach is that it is a simple approach to see the interest rate risk that a business is taking on. In other words, it is a simple way of assessing the hedging costs of a business.
Interest rate derivatives are forms of financial products that allow a business to hedge interest rate risk. This is a key strategy of financial risk managers, but it is also a complex strategy that is difficult to understand.
The beauty of an interest rate derivative is that it allows a business to manage the risk of interest rate volatility. In other words, it allows a business to hedge against rising interest rates. It is a simple way of smoothing out the cash flows that a business has to pay.
Here are some examples of interest rate derivatives:
An interest rate future is a contract that states that the difference in interest rates between two contracts will be settled at a predetermined date.
The futures market is essentially a way of controlling and managing interest rate risk. By purchasing an interest rate future, a business is essentially setting the cost of borrowing in terms of the future.
Here's what to keep in mind:
On that note, what kind of approach do you use when hedging interest rates? There are two ways to do it: depositing and earning interest, or borrowing and paying interest.
The simple approach would be to deposit a certain amount of money in a bank account. Then, you can earn interest on this account. When you earn interest on this account, the bank pays this interest to you.
All you can basically do is compare two or more interest rates and find out which bank will pay you the most interest. When you are done, you can withdraw the interest along with the principal.
You can also approach interest rate risk management from a different angle. All you have to do is borrow money from the bank and earn interest on it. When you borrow money from the bank, the bank will pay you interest.
When you pay the bank back, you have to pay the principal and the interest rate. This is the most common approach to managing interest rate risk.
An interest rate option is a contract that states that the buyer has the right, but not the obligation, to enter into a loan or deposit at a predetermined date, with a predetermined interest rate. By purchasing an interest rate option, a business is essentially setting the interest rates that it plans to borrow or lend at.
A cap is a contract that states that the buyer will receive a predetermined amount if the interest rate is higher than a certain interest rate. Meanwhile, a floor is the opposite of a cap. It is a contract that states that the buyer will receive a predetermined amount, if the interest rate is lower than a certain interest rate.
On the other hand, a collar is a combination of a cap and a floor, and it states that there will be a predetermined amount if the interest rate is lower or higher than a certain interest rate.
An interest rate swap is a contract that states that the buyer and seller will exchange interest payments on a predetermined loan or deposit without the buyer or seller actually having to enter into the loan or deposit.
Interest rate swaps are the simplest of all derivatives products. For this reason, they are ideal for businesses that need to manage their interest rate risk.
Investment and trading in the FX market carries a high degree of risk and may not be suitable for all investors. The steep leverage can work against you as well as for you.
Before deciding to invest in the currency you should carefully consider your investment objectives, level of experience, and risk appetite. The possibility exists that you could sustain a loss of some or all of your initial investment and therefore you should not invest money that you cannot afford to lose.
You should be aware of all the risks associated with foreign exchange trading, and seek advice from an independent financial advisor if you have any doubts.
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