Interest Rate Risk Management

The traditional method of managing interest rate risk has been fixed -rate borrowing in the form of loans . If is simple , & companies know how much they will need each year to service the debt, However, it is not always possible to obtain a loan at the rates, or for the amounts required.

An enterprise may wish to take precautions against interest rates moving up or down in the future , or many wish to change the existing structure of its funding or deposits , for instance for a fixed rate of interest to a floating rate. With the devolopmentof the financial markets & , in particular , the financial futures markets , a number of instruments have arisen which allow the treasurer to hedge interest rate risk.

Interest Rate Swaps.

An interest rate swap is an exchange of interest rate commitments , serch that a fixed -rate.

Commitment is exchanged for a floating-rate commitment. The parties to a swap retain their obligations to the orginal lenders . Which means that the swap parties must accept counter - party risk.Interest rate swaps are used for purposes other than obtaining a cheaper financing rate. They could , for example- be used to change future case flows or to enhance returns.Interest rate swaps are off balance sheet items , as the principal amount of the contract is not paid , & it is just an agreement to swap future cash flows. However, the existece of the swap should be maintained in the notes to the financial statements. The interest payments & receipts should be accrued over the life of the swap on a straight-line basis. Financial institutions which actively trade swaps revalue their positions the current market value.

Forward Rate Agreements.

A forward rate agreement ( FRA) is an agreement whereby an enterprise can lock in an interest rate today for a period of time starting in the future. On the future date the two counter parts in the FRA settleup & , depending on which way rates go , one will pay an amount of money to the other representing the difference between the FRA rate & the actual rate.

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