Skul Boondiskulchok November 22, 2011 12:00 am

Nowadays, most businesses have some kind of exposure to interest rate risk.

Such exposure can either be on the liability side when the firm needs to pay interest on loans and bond issuance, or on the asset side when the firm has some investment that is sensitive to changes in interest rates. Thus, this article will take a closer look at how interest rate swaps can be used as a tool to hedge interest rate risk more effectively.

Interest rate swaps (IRS) are a contract where one party agrees to pay a fixed rate, while the other party pays a floating rate in exchange. The reference rate for the floating leg can be either THBFIX (Thai Baht Floating-Rate Fix), or other more commonly used floating rates such as the Minimum Lending Rate (MLR) and Fixed Deposit Rate (FDR).

For a better understanding of how IRS works, let’s assume that a firm currently borrows money from the bank at the floating rate MLR for five years, but has a strong view that the interest rate is on a rising trend. In this case, the firm can enter into an IRS agreement with the bank to swap the floating rate MLR to a fixed rate for five years. Thus, a rising interest rate will no longer affect the firm as it has already swapped its floating rate MLR into a known fixed rate.

Although the firm can potentially make a large amount of money on IRS, the opposite can also take place. In this case, if the firm’s view is incorrect and the interest rate falls, it would lose the opportunity to enjoy paying a lower MLR floating rate for the remaining life of the loan contract — in other words the firm will face mark-to-market loss on the existing IRS contract.

Also, it is important to emphasise that the IRS contract is a separate contract from underlying contracts such as loan agreements and bond investments. For some types of loan contract, the bank gives the option to the borrower to prepay their money before the loan maturity date, and by doing so, the firm may need to settle an IRS contract according to its market value and separately from the loan contract.

In the end, IRS can be a good hedge against interest rate risk, but it needs to be used carefully as the mark-to-market gain or loss of the contract is potentially large. Lastly, the counter-party risk of the IRS contract should not be ignored as the interest rate risk hedging could fall apart simply because the counter-party cannot honour its obligation.

Skul Boodiskulchok is a dealer at Bangkok Bank.