Interest Rate Risk: Is It Time To Protect Your Firm From Rising Borrowing Rates?

The views expressed in this column are solely those of the author and do not reflect the views of SVB Financial Group, or Silicon Valley Bank, or any of its affiliates.

A firm cannot avoid interest rate risk when borrowing. The CFO or Treasurer with a loan based on a floating rate index, such as Prime or LIBOR, is exposed to the risk that short-term interest rates will rise, causing borrowing costs to rise. The tough questions are, of course, will rates rise further than they have done so already, and if so, will they rise fast and far enough to have a significant impact on your budgeted interest expense.

Without a lot of fanfare, expectations of short-term interest rates have risen considerably over the last few weeks. Eurodollar futures prices currently imply a 3-month LIBOR rate of 2.03 percent for the December 2012 contract, up from trading at 1.54 percent just three weeks ago and considerably higher than 0.28 percent, where 3-month LIBOR currently resides.

The London Interbank Offered Rate (LIBOR) is a reference rate based on the interest rates at which banks borrow unsecured from one another, and it is the most widely used benchmark for short-term interest rates in the world. The rate is set each day by the British Bankers Association, which calculates the average short-term inter-bank deposit interest rates among the most creditworthy banks.

The U.S. short-term interest rate market is one of the largest and most efficient in the world. All available information about our economy, inflation, and monetary policy is fully reflected in today's interest rates. The events that will drive the direction of tomorrow's and next year's interest rates are events that we may not fully anticipate today. In such an efficient market, a financial officer will find it difficult if not impossible to consistently "beat the market" by forecasting the direction of interest rates.

Diversification can be an important strategic tool in managing interest rate risk in these uncertain markets. A firm that hedges its floating rate debt financing will experience lower interest costs than unhedged firms if interest rates move higher.

One of the best diversification strategies involves creating a mix of fixed and floating rate debt. With floating rate debt, a firm borrows at the short end of the yield curve (where interest rates are usually lowest) and retains the ability to benefit in a stable to declining interest rate environment. With fixed rate debt, a firm is protected against future increases in short-term interest rates. A mix of fixed and floating rate debt helps a firm move toward an outcome that is better than the worst case scenario. (See Chart 1) Note that most firms cannot obtain fixed rate financing from their banks and even fewer are able to issue fixed rate notes or bonds, so they effectively create fixed rate financing by hedging their floating rate financing using interest rate derivatives.

Chart 1: Benefits of Diversification 

Source: SVB Financial Group 

A firm that decides to hedge their floating rate financing has several derivative instruments to choose from. A financial officer should be aware of the various choices before making a final decision. The two most popular derivative instruments used to hedge floating rate debt are interest rate swaps and caps. Here are the definitions for each:

Interest Rate Swap: An agreement between two parties to exchange or swap interest payments, based on a "notional" amount, through a specified maturity date. No principal payments are exchanged. A typical interest rate swap involves exchanging a swap fixed rate for a floating rate index — typically LIBOR or Prime.

Aside from the advantage of being able to lock in a swap fixed rate for the duration of the loan, the other key advantage in using a swap involves the ability to benefit from "bilateral pre-payment" — should you ever elect to terminate the swap prior to maturity and current interest rates are higher than they were at swap inception, you may actually receive a payment from your swap counterparty (your bank) equal to the change in market value of the swap. Conversely, the downside to bilateral pre-payment – should you elect on early termination and current interest rates are lower than they were at swap inception, then you will be required to make a payment to your swap counterparty equal to the change in market value of the swap. One other disadvantage: if interest rates drop or only increase slightly, then you may end up paying more in interest expense over the life of the swap compared to only having a floating rate facility with no swap.

Interest Rate Cap: A contract between two parties in which the cap seller agrees to pay the cap buyer if an interest rate index (e.g., LIBOR or Prime) rises above a specified level (the cap "strike rate"). In return for this insurance protection, the buyer pays the seller a premium shortly after the transaction is executed.

The cap premium is determined by the strike rate, the coverage period, the notional amount and the level of interest rate volatility. As a general rule, the cap premium will be higher when the strike rate is lowered, the coverage period is lengthened, the notional amount is increased or interest rate volatility is increased.

Each instrument has certain advantages and disadvantages over the other in terms of certainty, upside and downside risks and upfront costs. Each provides a distinct risk profile in different interest rate environments (see Chart 2).

Chart 2: Financial Risk Profile 

Source: SVB Financial Group 

As these instruments are typically traded between a financial institution and its client or between financial institutions, they are operating in the Over-the-Counter (OTC) derivatives market. One of the advantages of the OTC derivatives market is its flexibility. A firm can customize a transaction to hedge its own unique debt obligation. It can customize its: 1) coverage period — a derivative can start on a "spot start" basis or an a forward date of a firm's choosing, 2) notional amount — can be a constant amount through final maturity or it can amortize to match the underlying loan amount, or 3) floating rate index — can use LIBOR (one, two, three or six month) or Prime.

Managing financial risk is as much an art as it is a science. Hopefully, in this article I have described ways to potentially improve the odds of success. A growing number of finance officers are considering using interest rate derivatives to help manage their interest rate exposure in these increasingly uncertain markets.