The document discusses interest rate risk management techniques used by companies. It describes two main types of interest rate risk: mismatching of interest rate bases for assets and liabilities, and mismatching in the timing of repricing interest rate sensitive assets and liabilities. To manage these risks, the document outlines various outright and option based instruments that companies can use, including interest rate swaps, forwards, caps, floors, and collars. The goal is for companies to forecast interest rates and select the appropriate tools to match their assets and liabilities.

1. 1

2. 2
GROWING NEED FOR IRRM
* Volatility
* Increasing use of short
term financing

3. 3
INTEREST RATE RISK
1. BASIC RISK
- Mismatching of interest rate bases for assets and liabilities
in term of :
* Maturity * Denomination * Type
- Typical concern of Financial Firm
2. GAP RISK
- Mismatch timing in reprising interest rate sensitive assets
and liabilities
- Typical concern of Non Financial Firm

4. 4
MANAGEMENT OF
INTEREST RATE RISK
 Interest Rate Forecasting
 Selection of appropriate tools
* Outright Based Instruments
* Option Based Instruments

5. 5
OUTRIGHT BASED INSTRUMENTS
 Mismatched Maturity
 Foreign Currency Forward
Swaps
 Forward Rate Agreement (FRA)
 Interest Rate Swaps
 Currency Swaps

6. 6
1. MISMATCHED MATURITY
 Upward Slope - R long term > R short term
Borrow Short, Invest Long
 Downward Slope - R long term < R short
term
Borrow Long, Invest Short
OUTRIGHT BASED INSTRUMENTS

7. 7
OUTRIGHT BASED INSTRUMENTS
2. FOREIGN CURRENCY FORWARD SWAPS
Combining of two offsetting forwards
with different maturities
Illustration :
German Co will need USD 5,000,000 beginning in 6
months for 6 months period
Technique :
 Buy USD 5,000,000 forward 180 days
 Sell USD 5,000,000 forward 360 days

8. 8
OUTRIGHT BASED INSTRUMENTS
3. FORWARD RATE AGREEMENT (FRA)
- Interbank-traded contract to buy or sell
interest rate payment on a notional principal
- Buyer of FRA obtains the right to effectively
lock in an interest rate for desired term
beginning in the future
- Buy FRA if:
* Interest rate increase and Co will borrow
* Interest rate decrease and Co will invest

9. 9
FORWARD RATE AGREEMENT
Illustration :
USA Co. borrow USD 2,000,000 and buy 90 against 181
days FRA for a notional principal of USD 2,000,000
Agreed rate = 7.5 % Actual rate = 9.0 %
Interest rate payment
USD 2,000,000 x 0.09 x 91/360 = USD 45,500
Seller of FRA will pay
USD 2,000,000 x [(0.09 - 0.075) x 91/360] = USD 7,583.33
CF of USA Co. at end of loan :
Interest rate payment = USD 45,500.00
Cash Inflow from FRA = USD 7,583.33
Net Payment = USD 37,916.67

10. 10
OUTRIGHT BASED INSTRUMENTS
4. INTEREST RATE SWAPS
Fixed interest rate Floating interest rate
Plain Vanilla Swap
Agreement between 2 borrowers to exchange fixed
rate to floating rate

11. 11
PLAIN VANILLA SWAP
Illustration :
Unilever, UK MIC, USA
Available rate : Fixed 9 % Available rate : Fixed 10 %
Float LIBOR + 0.25 LIBOR + 0.75
Prefer borrow float Prefer borrow fixed
9 % 9.875 %
LIBOR LIBOR + 0.75
Advantage : Unilever MIC
Direct Borrowing LIBOR + 0.25 10 %
Interest Rate Swap LIBOR 9.875 %
Saving 0.25 % 0.125 %
Advantage for Citibank = 0.875 - 0.750 = 0.125 %
Unilever,UK MIC, USA
CITIBANK

12. 12
OUTRIGHT BASED INSTRUMENTS
5. CURRENCY SWAPS
Exchange debt service obligation in one
currency for the service on similar debt
denominated in other currency

13. 13
MANAGEMENT OF
INTEREST RATE RISK
 Interest Rate Forecasting
 Selection of appropriate tools
* Outright Based Instruments
* Option Based Instruments

14. 14
OPTION BASED INSTRUMENTS
1. INTEREST RATE CAP
Option to fix a ceiling or maximum short-
term interest rate payment
2. INTEREST RATE FLOOR
Option to fix a floor or minimum short-term
interest rate payment

15. 15
3. INTEREST RATE COLLARS
Simultaneous purchase (or sale) of a cap and
sale (or purchase) of a floor
Similar to Synthetic Forward Hedge
4. SWAPSION
The right but not the obligation to enter into a
swaps on a predetermined notional principal at
some defined future date at specific strike rate
OPTION BASED INSTRUMENTS

16. 16
SUMMARY
for managing debt service
TECHNIQUE I/R I/R
Mismatched Borrow short, Borrow long,
Maturity invest long invest short
FRA Buy FRA Sell FRA
Cap Buy Cap Sell Cap
Floor Sell Floor Do nothing
Collar Buy Collar Sell Collar
I/R Swap Float to fixed Fixed to float