Interest rate risk management

Interest rate risk is the potential loss in a firm's profitability and market value from unexpected changes in interest rates. Borrow at a floating rate pegged to the Bank of Zambia policy rate and a rise in that rate increases your borrowing cost directly; hold fixed-rate bonds and a rise in rates cuts their market value. Every company with floating debt or fixed-income investments carries the exposure.

• Repricing risk — assets and liabilities reprice on different dates: a 5-year loan funding a 3-year investment leaves a gap after year three.
• Basis risk — the reference rates on assets and liabilities move differently: a loan on LIBOR + 2% funding an asset priced off prime.
• Yield curve risk — changes in the shape of the term structure hit firms differently depending on whether they borrow long or short.
• Options risk — embedded call or put features create asymmetry: borrowers refinance when rates fall, lenders can't capture the upside when they rise.

In Zambia the exposure runs through the Monetary Policy Committee. Corporate borrowing tracks the policy rate with a spread — prime lending typically sits 3–5% above it — so an MPC rise cascades quickly to floating-rate borrowers and new fixed-rate loans. Treasury's job is to watch MPC statements and forward guidance, then decide: hedge, or carry the risk.

Treasury cannot manage what it cannot measure, and three tools quantify rate sensitivity. Gap analysis groups assets and liabilities by their repricing dates: the gap in any time bucket is rate-sensitive assets minus rate-sensitive liabilities.

A positive gap means more assets than liabilities reprice — rising rates lift net interest income. A negative gap means the opposite — rising rates cut it. The sign of the gap is what tells treasury whether to hedge and in which direction.

Duration is the sensitivity measure for fixed-income holdings; basis point value (BPV) translates it into money — the impact of a 0.01% rate move. On ZMW 1 million notional over six months, one basis point is 1,000,000 × 0.0001 × 0.5 = ZMW 50 a year. Small per point, which is exactly why exposures are quoted this way: multiply by the basis points you fear and the number becomes a decision.

A forward rate agreement (FRA) is an over-the-counter contract that locks in today an interest rate for a loan or deposit starting at a future date. No principal moves — only the difference between the agreed rate and the market rate is settled in cash.

The lecture's setting: it is March, a company's ZMW 1 million loan resets in six months, and the treasurer fears a rise. Six-month money costs 7% today; a dealer quotes 7.5% for six-month money starting in six months. The company buys the FRA at 7.5%.

Both rows end at 7.5% — that is the whole product. The FRA removes the uncertainty in both directions: protection against the rise, and surrender of the benefit of the fall. Whether that surrender matters is what separates FRAs from the options later in this step.

An interest rate swap exchanges periodic interest payments on a notional principal: one party pays fixed, the other floating, and the notional itself never moves. Swaps run longer than FRAs — typically 2 to 10 years — and let a firm transform its debt structure without refinancing: a floating borrower can become effectively fixed, or the reverse.

The deeper reason swaps exist is comparative advantage, and the lecture's example shows it. Zambia Sugar, rated AAA, can borrow at 10% fixed or LIBOR + 0.3% floating. Lafarge, rated BBB, faces 11% fixed or LIBOR + 0.5% floating. Zambia Sugar wants floating; Lafarge wants fixed. Note the asymmetry: Lafarge pays 1% more in the fixed market but only 0.2% more in the floating market.

So each borrows where it is relatively strongest — Zambia Sugar at 10% fixed, Lafarge at LIBOR + 0.5% floating — and they swap: Zambia Sugar pays LIBOR to Lafarge; Lafarge pays 10.1% to Zambia Sugar. Zambia Sugar's net cost is 10% − 10.1% + LIBOR = LIBOR − 0.1%, beating its own floating rate by 0.4%. Lafarge's net cost is LIBOR + 0.5% − LIBOR + 10.1% = 10.6% fixed, beating its own fixed rate by 0.4%. The 0.8% shared gain is the difference between the two penalties (1.0% − 0.2%).

Interest rate futures do an FRA's job on an exchange: standardised contracts that lock a borrowing or lending rate for a future date, liquid enough to close out at any time, at the price of margin requirements and fixed contract sizes.

The quoting convention carries the logic: prices are 100 minus the implied interest rate, so a contract at 97 implies 3%, and a rise in rates makes the price fall. A borrower hedges by selling futures — if rates rise, the price drops and buying back cheap yields a profit that offsets the dearer loan. A lender buys, for the mirror-image reason.

The hedge is not free even when it works: margin must be posted, and the position is marked to market daily, so cash moves through the account all the way to September. The rate certainty is the same as an FRA's; the difference is standardisation and liquidity against the FRA's exact fit.

Interest rate options give the buyer the right, not the obligation, to a rate — the asymmetry the binding instruments lack, paid for with an upfront premium. A cap lets a borrower pay at most the strike rate: if rates rise above it the seller reimburses the difference; if they stay below, the borrower walks away and loses only the premium. A floor is the lender's mirror — a minimum rate received. A collar buys a cap and sells a floor at once, using the floor premium received to cut the net cost of protection, at the price of giving away rate falls below the floor.

Compare the choice on one loan: ZMW 1 million resetting for six months, FRA available at 7.5%, or a cap at a 7.5% strike costing a ZMW 1,500 premium.

The FRA is cheaper if rates rise — certainty costs nothing extra. The cap wins if rates fall, because it never obliged you to give the fall up. That is the whole decision: pay a premium for the upside, or lock the rate and keep the premium. In an environment where rates could genuinely go either way, the optionality earns its ZMW 1,500.