Managing Short-term Interest Rate Risk

Most treasurers manage short term interest rate exposure by adjusting maturities on commercial paper issuance or changing from one LIBOR reset option to another on bank debt. Borrowers lengthen maturities when rates are expected to rise, shorten when they expect rates to drop. Sometimes, however, market movements can outstrip the treasurer's abilities to manage rate exposure using cash market alternatives alone.

Forward Rate Agreements (FRAs) were invented to fill this gap. FRAs offer a simple way to manage short term rate exposures without tying up the balance sheet.

What Are Forward Rate Agreements?
An FRA is a tailor-made futures contract. As the name implies, it is an agreement to fix a future interest rate today, for example the 6 month LIBOR rate for value 3 months from now (a 3 X 9 FRA in market terms). When the future date arrives the FRA contract rate is compared to actual market LIBOR. If market rates are higher than the contract rate, the borrower/FRA buyer receives the difference; if lower, he pays the difference. For the investor/FRA seller, the FRA flows would be reversed. Underlying borrowing or investment programs proceed normally at market rates, while the compensating payment provided by the FRA brings the hedgers' all-in cost or yield back to the base rate contracted for in the FRA.

Using FRAs
Companies use FRAs to protect short term borrowing or investment programs from market surprises. For example, a borrower with debt rollovers coinciding with a scheduled meeting of the Federal Open Market Committee, uses FRAs to lock rollover rates in advance.

FRAs also allow companies to take advantage when the yield curve inverts (long term rates fall below short term rates). When this happens a company which plans to borrow in the future would use FRAs to lock-in a future borrowing base rate at a level lower than today's rates.

FRAs are also valuable in making temporary adjustments to long term financial positions. For example, a company which has swapped floating rate debt to fixed can use FRAs to improve the swap's performance in the short run when short term rates are expected to decline. In this instance FRAs protect the value of future swap floating rate receipts from the impact of falling rates.

Other Tools for Short-Term Risks
Very short-term caps and floors (caplets and floorlets) complement FRAs in managing short term rate risk. Single period caps and floors limit exposure to very short term adverse rate movements while preserving the benefits of favorable market shifts.

Caplets and floorlets used in combination create cost effective hedges to fit almost any interest rate scenario.

Each of these tools enhances a hedge program by providing added flexibility and unique opportunities to improve control over short- term reinvestment and rollover rate risk.