Interest rate risk arises from potential losses due to fluctuating interest rates on assets or liabilities, and hedging strategies like Forward Rate Agreements (FRAs) are employed to minimize these risks.
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How do you manage
the risk financial risk associated with
interest rates?
So, so this interest rate risk remember
is about the possibility of you losing money
money
The question is why?
Because you might have an asset
that gives you income
based on interest rate.
Or you might even have a loan
borrowings. Yeah. That you have to pay interest
interest
that is also based on interest rate.
It's not impossible.
So you might some some people even
expect some payment to be made and that
payment might be tied to maybe rates or
maybe it's a late payment you get some
interest on top of it or whatever. So
whatever you have
that's exposive you to lose money
whenever interest rate changes then
that exact thing is exposing you to
interest rate risk and what you are
trying to do is to minimize that risk.
So you want to minimize it.
Which means take for instance if you
have a borrowing
that borrowing
definitely might have
an interest rate that is fixed.
And if that interest rate is fixed
then if the market interest rate reduces
which means normally you're supposed to
be paying lower if you have used market.
If they have already fixed it, you'll be
paying higher.
And the fact that you are paying higher
when you should be paying lower, you
will not be perfectly happy with that
because what you want is to always pay
The same way you might have a floating
loan that is a floating rate interest
loan where you are paying based on what
the market is saying.
So which means if the market is going up
your interest rate will be going up and
your interest expense as well will be
going up and you will not be happy at
that point you now be thinking oh had I
known I should have just fixed that rate
so that I don't have to be paying
interest rates that is very high so you
sometimes you can't tell
and that is the reason why you have to
think about edging
Because like I always tell you, edging
is not an opportunity for you to make
profit. Edging is not an opportunity for
you to make money. Edging is just a
strategy to minimize your loss.
loss.
And listen carefully is minimizing your
loss. It doesn't mean that you can
eliminate your loss.
Sometimes you might be able to depending
on your strategy but not all strategy
for edging interest rates will eliminate
it for you. But one thing for sure that
you need to know is that it doesn't stop
you from making loss. The same way it
might not stop you from making gain but
one thing you know for sure is that both
gain and losses will be very minimized
when you are edging. So what we're going
to look at now is how do we go about it?
This edging of interest rate risk. What
are the strategies? What are the
instruments that we have to use? What do
we need to do?
So we're going to look into various
strategies. Yeah. How do we manage
interest rate risk? The first thing that
I'm going to look at is the FRA which I
introduced to you briefly
when we were looking at risk management
FRA is the combination of two things.
Please take note because it's different
from your typical forward you use in currency
currency
f in forward currency all you needed to
do was just to fix the rate and you do
your transaction at that rate that's all
it's all about the FX rate but when
you're talking of FRA you're talking of
the interest rate itself
that you're trying to fix and also there
which is the road the amount that you are
are
actually trying to loan
or they are trying to invest if it's a
deposit cuz like I said in my introduction
introduction
your interest rate risk will be as a
result of either the loan that you have
or the asset that you have but both of
them are giving you value based on
interest it.
So for FRA few things I'm going to tell
you that you need to note. Yeah. And the
first thing is the fact that you need to
know when to buy or when to sell.
If you want to
to
pay at FRA, which means
you definitely have a loan,
you have a loan at an interest and you
think most likely in the future the loan
that you're planning to take or the loan
you currently have that is moving with
the market rate, the interest rate might
be going up. So which means when you
have a borrowing
remember your risk is always that rates
So which means you will prefer to fix
is to fix the rate so that you don't
have to pay at higher rate. You are
happy to pay at lower rate but you don't
want to pay at higher rate. So you fix
the rate.
When you fix the rate
what does that do for you? Please take
note when I buy or sell
buyers of FRA
will always remember when you buy
something you have to pay. Yeah. So that
helps you to remember buyers will pay at FRA
FRA
which means your interest will be at FRA
fixed I mean your forward rate agreement
rate and the sellers of FRA
will receive remember seller if you sell
something you will be expecting to
receive something so that helps you to
also memorize that at rate.
rate.
Yeah. So if you think about this
then you can see that if you have a
borrowing then it means that you need to
be buying FRA.
Yeah. Such that
you pay
And since sellers usually receives at
the forward rate agreement rate then you
then you should be a seller.
If you have a borrowing remember you
should be a buyer
but if you have a deposit you should be
a seller. Why should you be a seller?
cause your risk is the the fact that rates
rates
might come down. So if you know that
rates is likely going to come down, you
are happy to fix your rate and receive
at that fixed rate. So you are happy to
receive at fixed rate. So that's why if
you have a deposit then you want to be a
seller in an FRA agreement.
Very important to note this interpretation.
interpretation.
Yeah. Because
if you have a deposit which is an
investment, this is like investment.
That's what we're talking about. You're
meant to receive interest income at the
market rate or at the spot trade when
you go into that transaction in the
future. Yeah. So if you think in that
future rate would have come down then
what you want to do is to fix a rate
that your interest income will come in
the future and that's why you're using
the FRA and you are happy to fix.
So how do you know when you make
loss or profit
on FRA? That's another thing I'm talking
on under this first point of buying and
selling because when you are buying or
you are selling is for a purpose and
that is how it helps you to edge because
it is a profit or loss on your FRA that
is being added to the real transaction.
Remember what I said you always going to
have the real transaction regardless
right apart from your FRA that is on
interest rate. So which means that the
profit or loss that you're making on FRA
will be added to your actual outcome of
the transaction to really get your net
position. But how do you get your loss
or profit? One thing you need to first
of all understand is the fact that
whether you are a buyer
or you are a seller,
you will have to pay
an amount. Yeah. that is subject to the
outcome of the spot rate.
Yeah. Subject to the market rate. Yeah.
Or spot on transaction date.
And how do you know how much you are
Think about it this way.
If you are a buyer,
which is the agreed rate minus the spot.
So take for instance if
F has been agreed at 6%.
And come on the transaction date the
market rate is doing 4%.
for a buyer. A buyer must be definitely
someone that has borrowed money. So,
This person has a loan. If you have a loan
loan
and you have FRA fixed at 6% and come on
the day you want to really borrow your
money market is doing 4%.
You could see clearly that you are
disadvantaged because you could have
borrowed at 4% but unfortunately
you have borrowed at 6%.
Because you have fixed yourself at 6%.
So which means this is a loss for you.
That's why I call it you are paying. Remember
Remember
If you have to pay it means you are
making a loss.
But if you are receiving you are making
a gain. So and what how much is that
loss? F rate which is 6%
less the spot which is the market at 4%.
So you'll be paying at 2%. And you so buyer
pays at 2%.
Which means whoever sells this to him
will receive this money that the guy is paying
paying
at the same 2%.
Similarly, the same thing goes for seller
seller
but in a different direction. For a
seller, a seller will have to pay which
means a seller will be making a loss.
Yeah. Pays or making a loss
using this formula. this time around is
going to be at the spot the market rate
if
you are a seller which means you have a
deposit that is when you will sell
and you think rate will come down so you
And come in the future when the
transaction is about to take place the
market trade has now turned to
five let's say 6%.
Means you're going to be excited to say
yes I knew I knew the rate will come
down that is why I fixed at 7%. Look at
it market is doing 6% but it's no more
my problem because I already had a rate
fixed at 7%. And that is why if you see
how much is this guy going to pay spot
is 6%.
And FRA is 7%. So this is a negative one
in this case he's not paying negative 1.
Paying negative 1 means he's receiving
1% and that is again so it's a receipt.
So please take note.
So which means the seller receives 1% in
this scenario. And if it was the other
way around, it would have been the one
paying because by that time he fixed at 6%
6%
and the spot is doing 7% because it's
losing and that would have been a
positive one. That's the proper payment,
proper loss. So please take note because
I don't want this negative sign start
confusing you. Just note that that is
the formula. If you're going all you
need to do is to just know one formula.
You don't need to start I mean confusing
yourself. Once you know that the buyer
is F minus spot then the seller is spot
minus FRA. Then you know that whatever
happens to the buyer opposite happens to
the seller. Like in this scenario that
I've given you now where we discover
that the seller will have to pay minus
one which is the same thing as receiving
plus one because there's nothing like
paying negative.
Receiving plus one means it is a profit
for the seller. That means the buyer of
this kind of contract is making a loss
and in that case he will pay at 1%.
Please take note that's the very first
thing you need to know about FR. You
need to know when you are buying
and when you are selling and also how
your transactions can give rise to
payment or receipt because this outcome
this outcome 1% or 2% is what you need
to add to your real interest to your
principle to get your net position. Both
of these gives you your net position of edging.
Okay,
that's the first thing you need to know.
The second thing I'm going to mention is
the quotes.
The quotes
that you are used to
under FX
the FX tricks that we just finished is
different from the kind of code you will
see here. And also you might be thinking
maybe the code to be like 5% 3%
3%
like that but I'm going to get there.
The first thing I'm going to tell you
first of all is the fact that it has a
nomenclature a naming system that starts with
with
the time between now and when the
transaction is going to take place.
So take for instance if today is year zero
zero
and let's say this is January that's
today let's say January 1st year zero today
if you are looking to have a transaction
in 3 months
which means
March 31st
You want to sign an agreement.
The question is this loan agreement that
you are planning to sign in March. Yeah.
for the loan. Yeah. If the ten of that
loan is 6 months. So this is 6 months
and the delay is 3 months.
So today you are thinking of a
transaction that will occur in the
future which is a signing of a loan
agreement and that loan will be a six
What you are saying there is when you're
looking for quotes this is going to be
quoted as
because the the the edging period
remember is 3 months. That's where you
start from because this is today that
you're saying okay I don't know what the
rate will be by the time I'm signing
this loan in 3 months time. So I want to
do FR today to manage the risk of that
future. So which means I'm starting with
3 months
then dash
I know that this loan tenor is 6 month.
It's not going to be -6 because that is
a common mistake I've seen looking I
mean making instead because three months
already gone plus another six
is 9. So that's 6 + 3 then that means
what you are looking for is 3-9 F. So by
time we get into calculation and you are
seeing different
FR coded you should be able to identify
the right FR code. you should be using
because imagine in this transaction they
give you a quote say okay maybe 5% to 3%
then you have another one 3 to 8 fra
they give you maybe 3 to six or 4 to 8
like that like that you should know that
all these ones are noises and they're
nothing you should be using
right the quote for 3-9 is what has to
be relevant for you the other way is
they might also say 3 versus 9
is the same thing they are saying
whether they put dash or they put V
is the same thing.
The next thing you need to note about
how this is different is the way the
which you might probably have seen an
idea here.
You remember when we're doing currency
we always say there's a buy rate and
there's a sell rate.
And we believe that bank will always
sell at a higher rate than the buy rates.
rates.
That is for currency.
you need to understand the way the quote
is slightly different
and it's not that the principle is
different. The principle is still the
same thing. And what is the principle?
The principle is that the bank will
always make money on the transaction.
And which means if bank will always make money
money
on the transaction,
it means that bank will make sure that
when people give them money,
they pay
interest on that money.
that is much cheaper than the interest
that they will pay when they are giving
that same money out to people. So what
am I saying? Naturally what you will see
is that in interest rate quotes usually
you will see it looking like the higher
rate is being written first and the
lower rate is written after.
But whichever the case you see, the
bottom line is that you must know that
the bank will
will pay
pay
for investing which is people that are
giving their deposit to bank.
We pay a lower rate for
let me put it to investors so that it's
clear lower rates to investors whereas
whereas
higher rates from
So investors are like the lenders the
people that give their money to the bank.
bank.
So which means if you see a quote like
this means that 5%
is the borrowing rate and 3% is the
before I move on any question at this
So what we are saying
invariably is that when you have a borrowing
what is your risk
your exposure is that you don't want
Anybody that have borings will be so
And if you have deposit,
the problem is that you want to make
money and you will be having sleepless
And if you are exposed [snorts] to any
of this
and you want to use a far then
then
that is what we want to learn right now.
But remember what I said anytime you are
thinking of FRA you need to remember that
that
it is a combination of the FRA itself
which is the rate you're trying to agree
for the future plus the loan itself the principle
principle remember
remember
very important it's
it's
only when you have that combination that
you can actually say okay you are edging
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