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Principles of Finance

20.4 Interest Rate Risk

Principles of Finance20.4 Interest Rate Risk

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Table of contents
  1. Preface
  2. 1 Introduction to Finance
    1. Why It Matters
    2. 1.1 What Is Finance?
    3. 1.2 The Role of Finance in an Organization
    4. 1.3 Importance of Data and Technology
    5. 1.4 Careers in Finance
    6. 1.5 Markets and Participants
    7. 1.6 Microeconomic and Macroeconomic Matters
    8. 1.7 Financial Instruments
    9. 1.8 Concepts of Time and Value
    10. Summary
    11. Key Terms
    12. Multiple Choice
    13. Review Questions
    14. Video Activity
  3. 2 Corporate Structure and Governance
    1. Why It Matters
    2. 2.1 Business Structures
    3. 2.2 Relationship between Shareholders and Company Management
    4. 2.3 Role of the Board of Directors
    5. 2.4 Agency Issues: Shareholders and Corporate Boards
    6. 2.5 Interacting with Investors, Intermediaries, and Other Market Participants
    7. 2.6 Companies in Domestic and Global Markets
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Video Activity
  4. 3 Economic Foundations: Money and Rates
    1. Why It Matters
    2. 3.1 Microeconomics
    3. 3.2 Macroeconomics
    4. 3.3 Business Cycles and Economic Activity
    5. 3.4 Interest Rates
    6. 3.5 Foreign Exchange Rates
    7. 3.6 Sources and Characteristics of Economic Data
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  5. 4 Accrual Accounting Process
    1. Why It Matters
    2. 4.1 Cash versus Accrual Accounting
    3. 4.2 Economic Basis for Accrual Accounting
    4. 4.3 How Does a Company Recognize a Sale and an Expense?
    5. 4.4 When Should a Company Capitalize or Expense an Item?
    6. 4.5 What Is “Profit” versus “Loss” for the Company?
    7. Summary
    8. Key Terms
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  6. 5 Financial Statements
    1. Why It Matters
    2. 5.1 The Income Statement
    3. 5.2 The Balance Sheet
    4. 5.3 The Relationship between the Balance Sheet and the Income Statement
    5. 5.4 The Statement of Owner’s Equity
    6. 5.5 The Statement of Cash Flows
    7. 5.6 Operating Cash Flow and Free Cash Flow to the Firm (FCFF)
    8. 5.7 Common-Size Statements
    9. 5.8 Reporting Financial Activity
    10. Summary
    11. Key Terms
    12. CFA Institute
    13. Multiple Choice
    14. Review Questions
    15. Problems
    16. Video Activity
  7. 6 Measures of Financial Health
    1. Why It Matters
    2. 6.1 Ratios: Condensing Information into Smaller Pieces
    3. 6.2 Operating Efficiency Ratios
    4. 6.3 Liquidity Ratios
    5. 6.4 Solvency Ratios
    6. 6.5 Market Value Ratios
    7. 6.6 Profitability Ratios and the DuPont Method
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  8. 7 Time Value of Money I: Single Payment Value
    1. Why It Matters
    2. 7.1 Now versus Later Concepts
    3. 7.2 Time Value of Money (TVM) Basics
    4. 7.3 Methods for Solving Time Value of Money Problems
    5. 7.4 Applications of TVM in Finance
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  9. 8 Time Value of Money II: Equal Multiple Payments
    1. Why It Matters
    2. 8.1 Perpetuities
    3. 8.2 Annuities
    4. 8.3 Loan Amortization
    5. 8.4 Stated versus Effective Rates
    6. 8.5 Equal Payments with a Financial Calculator and Excel
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Problems
    12. Video Activity
  10. 9 Time Value of Money III: Unequal Multiple Payment Values
    1. Why It Matters
    2. 9.1 Timing of Cash Flows
    3. 9.2 Unequal Payments Using a Financial Calculator or Microsoft Excel
    4. Summary
    5. Key Terms
    6. CFA Institute
    7. Multiple Choice
    8. Review Questions
    9. Problems
    10. Video Activity
  11. 10 Bonds and Bond Valuation
    1. Why It Matters
    2. 10.1 Characteristics of Bonds
    3. 10.2 Bond Valuation
    4. 10.3 Using the Yield Curve
    5. 10.4 Risks of Interest Rates and Default
    6. 10.5 Using Spreadsheets to Solve Bond Problems
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  12. 11 Stocks and Stock Valuation
    1. Why It Matters
    2. 11.1 Multiple Approaches to Stock Valuation
    3. 11.2 Dividend Discount Models (DDMs)
    4. 11.3 Discounted Cash Flow (DCF) Model
    5. 11.4 Preferred Stock
    6. 11.5 Efficient Markets
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  13. 12 Historical Performance of US Markets
    1. Why It Matters
    2. 12.1 Overview of US Financial Markets
    3. 12.2 Historical Picture of Inflation
    4. 12.3 Historical Picture of Returns to Bonds
    5. 12.4 Historical Picture of Returns to Stocks
    6. Summary
    7. Key Terms
    8. Multiple Choice
    9. Review Questions
    10. Video Activity
  14. 13 Statistical Analysis in Finance
    1. Why It Matters
    2. 13.1 Measures of Center
    3. 13.2 Measures of Spread
    4. 13.3 Measures of Position
    5. 13.4 Statistical Distributions
    6. 13.5 Probability Distributions
    7. 13.6 Data Visualization and Graphical Displays
    8. 13.7 The R Statistical Analysis Tool
    9. Summary
    10. Key Terms
    11. CFA Institute
    12. Multiple Choice
    13. Review Questions
    14. Problems
    15. Video Activity
  15. 14 Regression Analysis in Finance
    1. Why It Matters
    2. 14.1 Correlation Analysis
    3. 14.2 Linear Regression Analysis
    4. 14.3 Best-Fit Linear Model
    5. 14.4 Regression Applications in Finance
    6. 14.5 Predictions and Prediction Intervals
    7. 14.6 Use of R Statistical Analysis Tool for Regression Analysis
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  16. 15 How to Think about Investing
    1. Why It Matters
    2. 15.1 Risk and Return to an Individual Asset
    3. 15.2 Risk and Return to Multiple Assets
    4. 15.3 The Capital Asset Pricing Model (CAPM)
    5. 15.4 Applications in Performance Measurement
    6. 15.5 Using Excel to Make Investment Decisions
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  17. 16 How Companies Think about Investing
    1. Why It Matters
    2. 16.1 Payback Period Method
    3. 16.2 Net Present Value (NPV) Method
    4. 16.3 Internal Rate of Return (IRR) Method
    5. 16.4 Alternative Methods
    6. 16.5 Choosing between Projects
    7. 16.6 Using Excel to Make Company Investment Decisions
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  18. 17 How Firms Raise Capital
    1. Why It Matters
    2. 17.1 The Concept of Capital Structure
    3. 17.2 The Costs of Debt and Equity Capital
    4. 17.3 Calculating the Weighted Average Cost of Capital
    5. 17.4 Capital Structure Choices
    6. 17.5 Optimal Capital Structure
    7. 17.6 Alternative Sources of Funds
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  19. 18 Financial Forecasting
    1. Why It Matters
    2. 18.1 The Importance of Forecasting
    3. 18.2 Forecasting Sales
    4. 18.3 Pro Forma Financials
    5. 18.4 Generating the Complete Forecast
    6. 18.5 Forecasting Cash Flow and Assessing the Value of Growth
    7. 18.6 Using Excel to Create the Long-Term Forecast
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  20. 19 The Importance of Trade Credit and Working Capital in Planning
    1. Why It Matters
    2. 19.1 What Is Working Capital?
    3. 19.2 What Is Trade Credit?
    4. 19.3 Cash Management
    5. 19.4 Receivables Management
    6. 19.5 Inventory Management
    7. 19.6 Using Excel to Create the Short-Term Plan
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Video Activity
  21. 20 Risk Management and the Financial Manager
    1. Why It Matters
    2. 20.1 The Importance of Risk Management
    3. 20.2 Commodity Price Risk
    4. 20.3 Exchange Rates and Risk
    5. 20.4 Interest Rate Risk
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  22. Index

Learning Outcomes

By the end of this section, you will be able to:

  • Describe interest rate risk.
  • Explain how a change in interest rates changes the value of cash flows.
  • Describe the use of an interest rate swap.

An interest rate is simply the price of borrowing money. Just as other prices are volatile, interest rates are also volatile. Just as volatility in other prices leads to uncertain cash flows for a company, volatility in interest rates can also lead to uncertain cash flows.

Measuring Interest Rate Risk

Suppose that a company is supposed to pay a bill of $1,000 in 10 years. The present value of this bill depends on the level of interest rates. If the interest rate is 5%, the present value of the bill is $1,0001 + 0.0510=$613.91$1,0001 + 0.0510=$613.91. If the interest rate rises to 6%, the present value of the bill is $1,0001 + 0.0610=$558.39$1,0001 + 0.0610=$558.39. The increase in the interest rate by 1% causes the present value of the expected cash flow to fall by 613.91 - 558.39613.91=0.0904=9.04%613.91 - 558.39613.91=0.0904=9.04%.

Interest rate risk can be highlighted by looking at bonds. Consider two $1,000 face value bonds with a 5% coupon rate, paid semiannually. One of the bonds matures in five years, and the other bond matures in 30 years. If the market interest rate is 5%, each of these bonds will sell for face value, or $1,000. If, instead, the market interest rate is 6%, the five-year bond will sell for $957.35 and the 30-year bond will sell for $861.62.

Notice that as the interest rate rises, the price of both of these bonds will fall. However, the price of the longer-term bond will fall by more than the price of the shorter-term bond. The longer-term bond price will fall by 1.38%; the shorter-term bond price will fall by only 0.43%.

Consider two additional $1,000 face value bonds. The difference is that these bonds have a 6% coupon rate, paid semiannually. If a bond has a 6% coupon rate and matures in five years, it will sell for $1,043.76 when the market interest rate is 5%. A 30-year bond that matures in 30 years and has a 6% coupon rate will sell for $1,154.54 when the market interest rate is 5%. However, if the interest rate in the economy is 6%, both of these bonds will sell for a price of $1,000. The price of the five-year bond will drop by 4.19%; the price of the 30-year bond will drop by 13.39%.

Think It Through

Calculating Bond Prices as the Interest Rates Changes

You are considering purchasing a $10,000 face value bond with a 4% coupon rate, paid semiannually, that matures in 20 years. If you require a 5% return to purchase this bond, what is the maximum price you would be willing to pay for the bond? If, instead, you require an 8% return to purchase this bond, what is the maximum price you would be willing to pay for the bond?

The sensitivity of bond prices to changes in the interest rate is known as interest rate risk. Duration is an important measure of interest rate risk that incorporates the maturity and coupon rate of a bond as well as the level of current market interest rates. Calculating duration is a complex topic that is beyond the scope of this introductory textbook, but it is useful to note that

  • the higher the duration of a bond, the more sensitive the price of the bond will be to interest rate changes;
  • the duration of a bond will be higher when market yields are lower, all else being equal;
  • the duration of a bond will be higher the longer the maturity of the bond, all else being equal; and
  • the duration of a bond will be higher the lower the coupon rate on the bond, all else being equal.

Swap-Based Hedging

As the name suggests, a swap involves two parties agreeing to swap, or exchange, something. Generally, the two parties, known as counterparties, are swapping obligations to make specified payment streams.

To illustrate the basics of how an interest rate swap works, let’s consider two hypothetical companies, Alpha and Beta. Alpha is a strong, well-established company with a AAA (triple-A) bond rating. This means that Alpha has the highest rating a company can have. With this high rating, Alpha can borrow at relatively low interest rates. Often, companies in this situation will borrow at a floating rate. This means that their interest rate goes up and down as interest rates in the overall economy vary. The floating rate will be tied to a benchmark rate that is widely quoted in the financial press. Historically, companies have often used the London Interbank Offered Rate (LIBOR) as the benchmark rate. Because published quotes for LIBOR will be phased out by 2023, firms are beginning to use alternative rates. As of yet, no single alternative has emerged as the most commonly used rate; therefore, LIBOR will be used in our example. Suppose that Alpha finds that it can borrow money at rate equal to LIBOR+0.25%LIBOR+0.25%; thus, if LIBOR is 2.75%, the company will pay 3.0% to borrow. If the company wants to borrow at a long-term fixed rate, its cost of borrowing will be 5.0%.

Beta has a BBB bond rating. Although this is considered a good, investment-grade rating, it is lower than the rating of Alpha. Because Beta is less creditworthy and a bit riskier than Alpha, it will have to pay a higher interest rate to borrow money. If Beta wants to borrow money at a floating rate, it will need to pay LIBOR+0.75%.LIBOR+0.75%. If LIBOR is 2.75%, Beta must pay 3.5% on its floating rate debt. In order for Beta to borrow at a long-term fixed rate, its cost of borrowing will be 6.75%.

Let’s consider how these two companies can enter into a swap in which both parties benefit. Table 20.5 summarizes the situation and the rates at which Alpha and Beta can borrow. It also illustrates a way in which an interest rate swap can benefit both Alpha and Beta.

  Alpha Beta
Bond rating AAA BBB
Floating rate LIBOR+0.25LIBOR+0.25 LIBOR+0.75LIBOR+0.75
Fixed rate 5 6.75
Rate company chooses Fixed at 5.0 Floating at LIBOR+0.75LIBOR+0.75
Swap N/A N/A
Beta pays Alpha fixed rate 5.5 -5.5
Alpha pays Beta floating rate -LIBOR +LIBOR
Payments and receipts -5.0 + 5.5  LIBOR-5.0 + 5.5  LIBOR -(LIBOR + 0.75)  5.5 + LIBOR-(LIBOR + 0.75)  5.5 + LIBOR
Net amount 0.5  LIBOR0.5  LIBOR -6.25
Benefit 0.75 0.5
Table 20.5 Example of a Swap Agreement

Alpha borrows in the capital markets at a fixed rate of 5%. Beta chooses to borrow at a floating rate that equals LIBOR + 0.75%. LIBOR + 0.75%.  Beta also agrees to pay Alpha a fixed rate of 5.5%. In essence, Beta is paying 5.5% to Alpha, 0.75% to its lender, and LIBOR to its lender.

In return, Alpha promises to pay Beta LIBOR. The exact amount that Alpha will pay to Beta fluctuates as LIBOR fluctuates. However, from Beta’s perspective, the payment of LIBOR it receives from Alpha exactly offsets the payment of LIBOR it makes to its lender. When LIBOR increases, the rate of LIBOR+0.75%LIBOR+0.75% that Beta is paying to its lender increases, but the LIBOR rate it receives from Alpha also increases. When LIBOR decreases, Beta receives less from Alpha, but it also pays less to its lender. Because the LIBOR it receives from Alpha is exactly equal to the LIBOR it pays to its lender, Beta’s net amount of interest paid is 6.25%—the 5.5% it pays to Alpha plus the 0.75% it pays to its lender.

Alpha is in the position of paying 5.0% to its lender and LIBOR to Beta while receiving 5.5% from Beta. This means that Alpha’s net interest paid is LIBOR  0.5%.LIBOR  0.5%. Alpha is said to have swapped its fixed interest rate for a floating rate. Because it is paying LIBOR  0.5%LIBOR  0.5%, it will experience fluctuating interest rates; however, as a company with a AAA bond rating, it is a strong, creditworthy company that can withstand that interest rate exposure. It would have cost Alpha LIBOR + 0.25%LIBOR + 0.25% to borrow the money from its lenders at a variable rate. By participating in this swap arrangement, Alpha has been able to lower its interest rate by 0.75%.

Through this swap arrangement, Beta has been able to fix its interest rate at 6.25% rather than having a variable rate. This predictability is a benefit for a company, especially one that is in a bit more precarious position as far as its creditworthiness and stability. The 6.25% Beta pays as a result of this arrangement is 0.5% below the 6.75% it would have paid if it simply borrowed from its lenders at a fixed rate.

Footnotes

  • 9The specific financial calculator in these examples is the Texas Instruments BA II PlusTM Professional model, but you can use other financial calculators for these types of calculations.
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