This lesson explores 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 fluctuations in interest rates that can affect a company’s borrowing costs and the value of its investments . Types include:

• Gap Exposure: The risk that arises from a mismatch between the maturities or repricing dates of a company’s assets and liabilities .

• Basis Risk: The risk that two variable interest rates with different bases change by different amounts, affecting the profitability of a hedge .

4.2. Traditional Methods of Management

Basic techniques for managing interest rate risk include :

• Matching and Smoothing: Matching the maturities of assets and liabilities, and smoothing the impact of interest rate changes over time.

• Asset and Liability Management: Structuring the balance sheet to limit exposure to rate changes.

• Forward Rate Agreements (FRAs): OTC contracts that fix the interest rate for a future period, protecting against adverse rate moves.

4.3. Interest Rate Derivatives

Advanced treasury management uses derivative instruments to hedge interest rate exposure :

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

• Interest Rate Futures: Exchange-traded contracts used to manage the risk of interest rate movements.

• Interest Rate Options: Contracts that give the holder the right to buy or sell an interest rate instrument, such as caps and floors.