How interest rate derivatives can be a powerful tool for managing risk and maximizing value Featured

8:00pm EDT March 26, 2010

Companies may be hesitant to use interest rate derivatives because they may appear too complex and their benefits may not always be clear at first glance.

In other cases, companies may be using the simplest kinds of swaps when a more sophisticated approach would serve them better or would be more consistent with their outlook on interest rates in general.

Smart Business spoke with Edwin Martinez, managing director in PNC’s Derivative Products Group, about the benefits of various kinds of interest rate derivatives.

What makes interest rate derivatives attractive right now?

Over the past year and a half, we have seen dramatic evidence of the damage that excessive or unmanaged risk can do to both businesses and to the economy. Yet taking on risk is unavoidable if you want to grow your business and improve your bottom line.

The answer to this dilemma is to address and actively manage the risks you can control to maximize the value of your business.

Interest rate derivatives can help you mitigate the risk of unpredictable interest rate swings. By adding certainty around this expense category on your income statement at a time when improving margins is critical, you can ensure that more of each revenue dollar drops to the bottom line.

Interest rate derivatives are often considered difficult to understand. How do they work?

Interest rate derivatives, such as swaps, are contractual agreements between the bank and a client. The parties agree to exchange different forms of interest payments through a stated maturity date. In one of the most popular versions, interest rate swaps effectively convert a floating rate on a loan to a fixed rate.

To visualize how an interest rate swap works, take the situation of the floating rate borrower who feels that rates will rise over the term of a loan, significantly increasing interest costs and potentially eroding already strained operating margins. This client enters into a swap agreement with the bank, whereby the client receives a floating rate, such as LIBOR, that offsets the interest on its underlying loan agreement and pays a fixed rate.

The payment of LIBOR from the bank to the client offsets the client’s LIBOR payment to the lender. After the LIBOR payments cancel each other out, the client is left with an effective all-in fixed rate consisting of the swap rate plus the spread over LIBOR.

What are some other interest rate derivatives companies should consider?

There are many variations of interest rate derivatives that companies might want to consider, depending on their current debt structure and their outlook on interest rates. Let’s discuss one in more detail. If the company believes that rates will remain low for the near term and would like to take advantage of the floating rate environment while still protecting against too much risk, it may want to consider an interest rate cap.

Interest rate caps provide protection should rates rise above a prespecified rate, offering essentially an insurance policy against a large or unacceptable increase. The company chooses the acceptable level of risk by selecting a strike rate that corresponds to a manageable worst-case scenario.

In this scenario, companies can actively manage their interest rate exposure within their acceptable risk threshold rather than eliminate it entirely.

In addition to managing risk and ultimately increasing business value, derivatives such as interest rate swaps and caps deliver other benefits.

  • Derivatives can be customized to meet a company’s timing and cost needs.
  • Companies can choose the index they want to base the derivative on. Derivatives can be structured based on various indices such as Prime, Commercial Paper, Fed Funds, SIFMA and others, as well as LIBOR.
  • A derivative can be terminated at its market value at any time.
  • Derivatives are independent transactions from the underlying credit facility.

Derivatives such as interest rate swaps and caps are powerful risk management tools that can help you create value in your business. Other strategies that you may want to consider include floors, collars, swaptions and cash settled swaps.

This article was prepared for general information purposes only and is not intended as legal, tax, accounting or financial advice, or recommendations to buy or sell currencies or to engage in any specific transactions, and does not purport to be comprehensive. Under no circumstances should any information contained herein be used or considered as an offer or a solicitation of an offer to participate in any particular transaction or strategy. Any reliance upon this information is solely and exclusively at your own risk. Please consult your own counsel, accountant or other advisor regarding your specific situation. Any views expressed herein are subject to change without notice due to market conditions and other factors.

© 2010 The PNC Financial Services Group Inc. All rights reserved.

Edwin A. Martinez is managing director, Derivative Products Group at PNC. Reach him at edwin.martinez@pnc.com or (216) 222-9646. To learn more about interest rate derivatives, visit pnc.com/ideas.