The Interest rate hedging products enable customers to remove uncertainties with respect to changes in the interest rates. For example, Borrower taking on a floating rate loan over a number of years in the future would be exposed to sharp rises in the interest rate over the period of the loan. A number of tools are available with which customers can hedge this risk.
Interest Rate Swap
An Interest Rate Swap is an agreement between the bank and customer to exchange one set of interest payments for another. Interest payments are calculated on a nominal amount for an agreed period. Payments are made on an agreed schedule.
A customer who has borrowed over a three years period at a floating rate with three month rollovers is exposed to a move higher in the three months SIBOR (Saudi Interbank Offered Rate). The customer can choose to enter into a swap transaction with the Bank in which the customer will receive three months SIBOR from the Bank in exchange for paying a fixed rate on an quarterly basis.
In the swap transaction, therefore, the customer will receive three months SIBOR which will offsets the SIBOR payment on the loan. The customer will be only required to pay a known fixed amount on the swap, thus removing the risk of increase in the three months SIBOR rate.
Forward Rate Agreement (FRA)
A forward rate agreement is an agreement between the bank and customer that fixes the rate on a loan (or deposit) for a period starting in the future.
For example a customer can fix the rate on a six month loan starting in three month. It is therefore possible, using FRA’s, to fix a whole range of future periods. In this case the profile of an FRA is similar to an interest rate swap.
FRA’s are usually used for fixing periods up to two years.
Interest Rate Options
Interest Rate Options operate in a similar way to FX options offering protection against adverse movements in interest rates yet allowing the buyer of the option the flexibility to fix his rate at a more opportune rate should the markets move in his favor.
An interest rate cap allows a borrower to fix his maximum rate for borrowings over a set period. An interest rate floor acts in the exact opposite way allowing an investor to set the minimum return on an investment. Naturally as is the way with FX options, a premium is payable for this protection.
As a way of mitigating the cost of an interest rate option a borrower may although agree the minimum rate he will pay on his loan, thus reducing or in certain cases mitigating completely, the premium payable. This product is called an interest rate collar and is simply a combination of a cap but sells the floor thus offsetting the premium cost.
An interest rate corridor is a further combination where the cost of buying the cap is offset by selling a cap at a higher rate thus limiting the amount of protection. This would be used in an environment where rates are expected to rise but not dramatically.