Management of Interest Rate Risk Using Derivatives

Abstract

This article explains the application of derivatives focusing on their utility in managing the interest rate risk faced by different companies. In times of volatile market environment, when interest rates have an unstable pattern, the companies borrowing large amounts wish to protect themselves against adverse movements in interest rate. The adverse movements could have a significant impact on interest expenses by increasing the interest payments and consequently on their profitability and on the shareholder value. On the other hand, the companies lending money would want to hedge against interest rate falling as their interest incomes are directly proportional to the level of market rates. The issues is becoming more challenging in the actual asset and liabilities management, as the ability to model on a dynamic basis the impact on net interest income of changing interest rates is becoming more and more complex. In this article I will explain how the interest rate derivatives work and recommend the one which would be more appropriate to apply having in consideration the Romanian market in a particular scenario.

Keywords: Derivatives, Forward rate agreement (FRA), Interest rate risk, Risk management.