Interest rate hedging is a series of techniques that investors can use to minimise the effects of changing interest rates on their finances. These techniques apply to a variety of situations and needs, including those of bond buyers, corporate borrowers, stock investors and traders with more complex needs. Interest rate hedging can use a variety of instruments to protect investor wealth.
Investors have always had to worry about fluctuating interest rates. For most of history, they had two basic options: they could get a long-term, high fixed rate of interest by purchasing bonds, or they could get a short-term rate that fluctuated over time. While long-term debt had higher average returns, it also carried more risk, since a rise in interest rates could destroy its value. Short-term debt carried fewer risks, but more volatility in return. An investor could not count on any particular income from year to year. Interest rate hedging appeared to help manage this risk, by allowing companies and individuals to determine in advance how much fluctuation and how much loss they could tolerate.
Hedging for borrowers
When borrowers hedge interest rates, their primary goal is to avoid a sudden spike in interest rate payments. A borrower might be willing to pay the prime rate plus 3 per cent when the prime rate is at 2 per cent, but this might be unprofitable if the prime rate rises to 5 per cent. To avoid this eventuality, such a borrower could enter into a swap agreement with a bank, whereby he would pay the bank a fixed rate, and the bank would pay him a rate based on the prime rate, on an amount that approximated the value of their loan. When the prime rate went up, the loan costs would go up, but the swap would pay more. When the prime rate dropped, the swap would pay less, and the loan would cost less.
Hedging a portfolio
The simplest way to hedge interest rate risk in a portfolio is to purchase short-term securities whose value will not fluctuate significantly given higher interest rates. Another technique is to hedge this risk by purchasing put options on long-term debt (especially even longer-term debt than the debt in the portfolio). These options will pay off if interest rates drop, and if they rise, the rise in the value of the bonds will pay for the costs of the put options.
Hedging complicated risks
If an investor owns a long-term bond that does not have any kind of derivatives (for example, a private bond issued by an obscure company), the only way to hedge interest rate risks is to bet directly on the rates. This can be done by selling short treasury securities with a similar maturity to that of the bond. If rates rise, the securities will drop in value in a way that compensates the bondholder. This technique carries risks, though. If the hedging portfolio shows a loss, but the hedged asset is not considered collateral, the investor may be forced to liquidate.
Many banks offer custom interest rate swaps for their clients. These swaps are designed to perfectly hedge the customer's unique interest rate risks. These can be sold to borrowers, bondholders, or even individuals who fit into both categories.