This lesson examines the sources of interest rate risk and the instruments used to manage it.

4.1 Sources of Interest Rate Risk
Interest rate risk arises from :

• Floating Rate Debt: Borrowings where the interest rate resets periodically.

• Fixed Rate Debt: Borrowings where the interest rate is fixed, creating exposure to changes in the value of the debt.

• Cash and Investments: Surplus cash investments that are sensitive to interest rate changes.

4.2 Derivatives for Interest Rate Hedging
Treasurers use various derivatives to manage interest rate risk :

• Forward Rate Agreements (FRAs): Over-the-counter contracts that fix an interest rate for a future period.

• Interest Rate Swaps: Agreements to exchange fixed-rate interest payments for floating-rate payments (or vice versa).

• Interest Rate Futures: Standardised exchange-traded contracts to buy or sell an interest rate-sensitive instrument at a future date.

• Interest Rate Options: Contracts giving the holder the right, but not the obligation, to buy or sell an interest rate-sensitive instrument.

4.3 Interest Rate Risk Measurement
Measuring interest rate risk involves calculating :

• Gap Analysis: Measuring the difference between interest-rate-sensitive assets and liabilities over various time buckets.

• Duration Analysis: Measuring the price sensitivity of a fixed income portfolio to changes in interest rates.

4.4 Controlling and Reporting Interest Rate Risk
Effective management includes :

• Setting Limits: Defining the acceptable level of interest rate risk.

• Monitoring Exposures: Regularly monitoring the company’s interest rate position.

• Reporting: Providing timely and accurate information to senior management and the board.