Financial Managers also have to be aware of the risks involved with changes in interest rates. These can be classified as:
- Interest rate risk – Refers to the negative movements in interest rates. For example either the loan interest increases or the deposit interest rate decreases. The corporate treasurer has to ensure this effect is minimised amongst businesses.
- Gap risk – The level to which interest rates risk affects an organisation.
Interest Rate Fluctuations
To analyse how the change of interest rates affects investments, the yield curve is used. Financial managers use the yield curve to decide on terms of borrowing or deposits since the curve gives an estimate of the likely future movement in interest rates. For example, if a business wants to borrow money, if the yield curve shows an upward curve the financial manager may decide to choose fixed-term rates because interest rates are likely to rise.
The yield curve is affected by:
- Liquidity preference theory – Assumes investors that take more risky investments will require greater return/yields.
- Expectations theory – Assumes the shape of the yield curve is dependent on an investor’s expectation of interest rates.
- Market segmentation theory – Assumes that there is no relationship between long and short-term interest rates and that most investors have set preferences regarding the length of maturities that they will invest in and therefore cannot be easily substituted.
Interest Rate Risk Hedging Techniques
The hedging techniques used to minimise interest rate risk are:
- Forward rate agreements (FRA) – When a company and bank set an agreed rate of interest for borrowing or depositing in advance. For example, the bank will pay a company the difference if interest rates for borrowing increase whilst if they decrease the company will pay the difference to the bank.
- Interest rate guarantees (IRG) – This is an option to a company to protect itself against adverse interest rate movements whilst taking advantage of favourable movements. This option is more expensive than the FRA.
- Interest rate futures – Sets a fixed rate on larger loans and investments that can be traded.