Interest Rate Hedge
From FXPedia
Changes to interest rates are watched very closely by all market participants but fixed income investors are particularly mindful of interest rate fluctuations. This is because interest rates maintain an inverse relationship with fixed income valuations.
Fixed income is a generic term for any investment that provides a regular or constant stream of income and includes instruments such as bonds, preferred stocks, loans to a second party paying interest, pensions, and so on. There is a very active secondary market for bonds where investors can buy and sell existing bonds and par values are determined by the coupon rate, time to maturity, and the credit-worthiness of the issuer.
Fixed income investments are susceptible to interest rate changes for the obvious tendency for investment capital to naturally flow to where the greatest returns can be obtained. This is hardly a radical concept, but the following example of a fixed rate bond demonstrates the inverse relationship that exists between interest rates and fixed income values.
Imagine that you have just purchased a government bond with a nominal or face value of $1,000 that matures in ten years. Based on the prevailing interest rate in the economy currently averaging 6%, the bonds were issued with a coupon rate (i.e. the interest earned by the bond) of 7% to ensure the bonds are competitive as an investment vehicle.
However, two years later, assume that interest rates have decreased to 5% - this would result in a lower coupon rate for new bonds – perhaps somewhere in the 5.5% range. This means that the guaranteed rate of 7% for the bond you purchased two years earlier looks even better than when you bought it originally. It looks so good in fact, that the bond – which you bought for $1,000 – may be valued at $1,100 on the bond market as it ensures a return 1.5% greater than what is currently offered.
Like everything in the markets however, the swing could go the other way; if interest rates rise to say 8%, the new bonds may be offering a coupon rate of 9% which makes your 7% bond a rather unattractive investment. In fact, if you were to try to sell your bond on the secondary bond market, you might find that the par value has dropped to $800 – certainly it would be less than what you paid.
A common hedging strategy to protect against an interest rate increase is to enter into a Forward Rate Agreement (FRA) or an interest rate swap agreement. Both hedging techniques are similar and consist of a principle holder and a second party agreeing to exchange one interest stream for another.
Forward Rate Agreement / Interest Rate Swap
A forward rate agreement (FRA) is a derivatives-based financial instrument in which one party (the buyer or borrower) agrees to pay a fixed interest rate to another party (the seller or the lender). The fixed rate is calculated for a specified notional amount (i.e. the principal) that is owned and retained by the seller of the FRA for the duration of the transaction. In return for payment of the fixed rate at the end of the agreement, the buyer receives the proceeds the notional amount earns for the time period based on a floating reference rate. The reference rate can be any recognized rate with the LIBOR rate being one of the most common benchmarks used for FRAs.
Interest rate swaps are handled in a similar fashion – a basic interest rate swap is simply an agreement whereby two counterparties exchange (i.e. “swap”) the accrued interest on a set notional amount (the principal), in exchange for an agreed upon fixed interest rate for a specified time period. Each side of the swap is referred to as a leg, with one leg tied to a floating market return benchmark (such as the LIBOR rate) while the other leg is fixed to an agreed-upon interest rate to be paid by the buyer of the swap to the owner of the principle. Whereas FRAs usually require payment of accrued interest to the principle holder when the FRA matures, interest rate swaps typically require payments during the course of the agreement.
For the principle holder, interest rate swaps and FRAs represent little risk as no principle is transferred between counterparties and the return is guaranteed. For the buyer or speculator, there is the opportunity to generate income without the need to provide their own investment capital and as long as the benchmark provides a greater return than the interest they have agreed to pay the principle holder, a profit can be realized. The downside of course, is that the benchmark fails to outperform the guaranteed rate resulting in an overall loss.
Related Links
