Interest Rate Hedging
As interest rates represent the effective cost of borrowing, a sudden rise in interest rates can have detrimental impacts on a company or individual’s pre-planned cost structure. In particular, companies utilizing floating rate financing expose themselves to sizable risks. However, it is possible to hedge interest rate exposure and more effectively manage risk.
A simple interest rate hedging strategy can be used to minimize the impact of unforeseen fluctuations and provide a less volatile cost of financing. Interest rate hedging will not maximize profits but will effectively eliminate uncertainty of a floating rate and act as insurance against unfavourable changes as the position in the futures market will offset gains or losses in the borrowing market.
Banker’s Acceptance Notes as a Hedging Instrument
Banker’s acceptance notes are a negotiable piece of paper that function as a post-dated check whereby the bank rather than the account holder guarantees payment. Futures on banker’s acceptance notes are available with quarterly expiry in March, June, September and December and utilizing them can effectively lock in the party’s Canadian Dealer Offered Rate (their cost of borrowing) for periods in multiples of three months. A hedge is an investment that is used by commodity producers, end users and traders to protect against negative price fluctuations. Hedging is not intended to produce large profits but rather to minimize possible losses. A hedge can be implemented through the use of a financial derivative on the futures market to establish an individual’s price ceiling for a commodity.
Common Situations that Benefit from Interest Rate Hedging