This lesson explores the management of interest rate and commodity price risk.

3.1. Managing 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. For significant banks, net interest income makes up a substantial portion of their operating income, making effective management of this risk critical .

Treasurers can manage interest rate risk using various instruments:

• Forward Rate Agreements (FRAs): 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) . A basis swap involves both legs being variable rates but using different benchmarks .

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

• Caps and Floors: Options that protect against rising or falling interest rates.

3.2. Understanding Commodity Risk

Commodity risk arises from exposure to price movements in raw materials and other commodities. This can significantly impact a company’s input costs and profitability, depending on the industry. The University of Melbourne’s treasury curriculum covers “commodity price risk management” as part of its syllabus .

Managing commodity risk involves similar techniques to FX and interest rate risk:

• Forward Contracts: Locking in prices for future purchases or sales.

• Futures and Options: Using exchange-traded instruments to hedge commodity exposure.

• Commodity Swaps: Exchanging a fixed commodity price for a floating one.