Interest Rate Risk is Critical and Here is How to Hedge It

By Chase Nerison

Interest rate risk will always be a prevalent concern needing attention from financial institutions. Many FIs have to live with risks like credit, liquidity, and market, but luckily, hedging interest rate risk is doable. These rates are significant players in the market as they affect stocks, bonds, borrowing, lending, and more. Generally, all FIs hedge against interest rate risk as it cannot be ignored. Check out “Why Interest Rates are a Big Deal in Investment Banking” published on this website on October 25 for more information on this topic.

Following the stock market and financial news closely, interest rates and Federal Reserve activity is of interest as we expect the federal funds rate and discount rate to increase in 2022, which in turn increases overall interest rates. After increasing the money supply with the stimulus packages and lowering interest rates due to the pandemic’s negative effect on the economy, inflation is a concern of many, and interest rates have nowhere to go but up. As we prepare for this change, it will be important to continue to hedge interest rate risk.

First, interest rate risk is defined as the potential for investment losses that result from a change in interest rates. For example, if interest rates rise, the value of a bond or other fixed income asset will decline as interest rates and bond prices are inversely related. The change in a bond’s price with a change in interest rates is referred to as duration. One strategy to reduce interest rate risk is to hold bonds of different durations, which can also be associated with different maturity dates. This is a form of laddering strategy. Most other forms of hedging are through derivatives, which is something that has a value derived from other assets like stocks, bonds, interest rates, or currencies. These derivative instruments include:

1. Forward Rate Agreements (FRAs)

2. Futures Contracts

3. Interest Rate Swaps

4. Options Contracts

A forward rate agreement can reduce interest rate risk by entering into a private contract with another party where the determinant of gain or loss is an interest rate. One party pays a fixed interest rate and receives a floating interest rate. The notional principal amount is settled in cash at the end of the forward contract. These are very common in borrowers and lenders exposed to significant interest rate risk at a single future date. Though similar to a swap, each FRA in a series is priced at a different rate unless the term structure is flat. See an FRA payoff graph below.

A futures contract is similar to an FRA but with less risk of default and lower liquidity risk. These contracts have an intermediary which means they are standardized and can be reversed by purchasing another entity. Additionally, these futures contracts are usually publicly traded, unlike FRAs.

The third type of derivative is interest rate swaps. Easily interpreted, a swap is an exchange. It is a combination of FRAs with an agreement to exchange sets of future cash flows. The most common type of interest rate swap is called a plain vanilla swap which is very similar to FRAs. This involves one party paying a fixed interest rate and receiving a floating rate while the other is paying a floating rate and receiving a fixed rate as shown below.

The fourth common derivative is an options contract. This is used to protect parties with a floating-rate loan, like adjustable-rate mortgages. These are typically bought in groups as an interest rate cap is a grouping of call options and an interest rate floor is a grouping of put options. For example, a borrower going long could pay a premium and purchase a cap, also called a ceiling, and receive cash payments from the cap seller if the interest rate exceeds the cap’s strike price. In a company’s financials, this can be categorized by interest rate expense if it expires worthless. Another type of options strategy is the protective collar. This lowers potential profitability as you buy a cap and sell a floor or sell a cap and buy a floor.

Those four strategies are the most common interest rate hedges used by financial institutions. Big banks often use a statistical method using regression analysis and many scenarios to estimate the potential change to net interest income. This also provides them with the ability to determine the effectiveness of their hedging.

Along with those four strategies, there are other ways to hedge interest rate risk. One strategy is to shorten the maturities of bonds. This will decrease your susceptibility to interest rate changes with lower duration. Second, buying Treasury Inflation-Protected Securities (TIPS) is a good hedge. They have low fees and high liquidity, but this switch only protects you from inflation being the source of interest rate increases. This could be more beneficial now than ever if you fear inflation. Third, you could buy a hedged bond fund like the iShares Interest Rate Hedged Corporate Bond ETF. Since they hedge some or all of their interest rate risk, this leaves the purchaser with pure credit exposure. This protects well against inflation, but deflation could hurt both sides. Lastly, purchasing an interest rate volatility and inflation hedge like IVOL or buying a put on a bond fund are good hedges against inflation. Rather than these last two, I would advise putting your money towards TIPS as IVOL’s 1% expense ratio and options can be expensive.

Interest rate risk will continue to play an important factor in the market as it is a key determinant of many assets. With anticipated Fed activity coming in early 2022, interest rates will be highly watched. To protect the retail investor or even a large financial institution, it is smart and common to hedge against this risk. The four common hedges are derivatives: forward rate agreements (FRAs), futures contracts, interest rate swaps, and options contracts. All of these hedges cost money, but interest rate expenses are necessary to protect from big losses and even bankruptcy.

Works Cited

Baldwin, W. (2021, June 30). Seven ways to hedge interest rates. Forbes. Retrieved October 30, 2021, from https://www.forbes.com/sites/baldwin/2019/09/21/seven-ways-to-hedge-interest-rates/?sh=89368306f470.

Norris, E. (2021, October 25). Managing interest rate risk. Investopedia. Retrieved October 30, 2021, from https://www.investopedia.com/articles/optioninvestor/08/manage-interest-rate-risk.asp.