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Chapter 4

7.2 The impact of increasing interest rates on business

 Some costs may rise higher interest rates raise the cost of finance

 Investment falls Higher cost of capital reduces value of
investment

 Sales revenues may fall Consumers spend less due to higher cost of
credit, mortgages, etc.

7.3 Managing interest rate risk

 On imminent new loans/deposits could choose fixed rate products

 Forward rate agreement (FRA) – e.g. borrowing in 3 months’ time

– Buy an FRA now

– In 3 months’ time borrow on market at prevailing rate

– If loan rate > FRA rate then receive cash under the FRA for the difference

– If loan rate < FRA rate then pay cash under the FRA for the difference

– Net position (loan + FRA) is a fixed interest rate.

 Interest rate guarantee (IRG) is an option on an FRA

– Buy an IRG now

– In 3 months’ time borrow on market at prevailing rate

– If loan rate > FRA rate then exercise IRG to acquire FRA and receive cash

– If loan rate < FRA rate then allow IRG to lapse

 Interest rate futures

– Net position (loan + future) is a fixed interest rate

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