abhishreshthaa
Abhijeet S
) Interest rate uncertainty exposes a firm to the following kinds of risks:
1. If the firm has borrowed on a floating rate basis, at very reset date, the rate for the following period would be set in line with the market rate. The firm’s future interest payments are therefore uncertain. An increase in rates will adversely affect the cash flows.
2. Consider a firm, which wants to undertake a fixed investment project. Suppose it requires foreign currency financing and is forced to borrow on a floating rate basis. Since its cost of capital is uncertain, an additional element of risk is introduced in project appraisal.
3. On the other hand, consider a firm, which has borrowed on a fixed rate basis to finance a fixed investment project. Subsequently inflation rate in the economy slows down and the market rate of interest declines. The cash flows from the project may decline as a result of the fall in the rate of inflation but the firm is logged into high cost borrowing.
4. A fund manager expects to receive a sizable inflow of funds in three months to be invested in five –year interest rate will have declined thus reducing the return on his investments.
5. A bank has invested in a six-month loan at 18% and financed it by means of a three-month deposit at 16.5%. At the end of three months it must refinance its investment. If deposits rates go up in the mean while its margin will be reduced or may even turn negative.
6. A fund manager is holding a portfolio fixed income securities such as government and corporate bonds. Fluctuations in interest rates expose into two kinds of risks. The first is that the market value of his portfolio varies inversely with interest rates. This is the risk of capital gains or losses. Secondly he receives periodic interest payments on his holdings, which have to be reinvested. The return he can obtain on these reinvestments in uncertain.
In each of these cases, an adverse movement in interest rates hurts the firm by either increasing the cost of borrowing or by reducing the return on investment or producing capital losses on its assets portfolio. During the early 80’s investor’s preferences shifted towards floating rate instruments thus exposing borrowers to substantial interest rate risks.
For most Indian companies the idea of interest rate risk is relatively new. In an environment of administered rates and fragmented, compartmentalized capital markets, neither investors nor borrowers felt the need to worry fluctuations in interest rates.
With increasing resort to external commercial borrowings, Indian companies have had to recognize and learn to manage interest rate risk. Also, the Indian financial system is gradually moving in the direction of market determined interest rate risk.
Also, the Indian financial system is gradually moving in the direction of market determined interest rates. During the last few years the environment has changed drastically. In particular, the steep rise in interest rates during 1995-1996 has led to the painful realization that careful management of the interest rate risk is crucial to a firm’s financial health.
1. If the firm has borrowed on a floating rate basis, at very reset date, the rate for the following period would be set in line with the market rate. The firm’s future interest payments are therefore uncertain. An increase in rates will adversely affect the cash flows.
2. Consider a firm, which wants to undertake a fixed investment project. Suppose it requires foreign currency financing and is forced to borrow on a floating rate basis. Since its cost of capital is uncertain, an additional element of risk is introduced in project appraisal.
3. On the other hand, consider a firm, which has borrowed on a fixed rate basis to finance a fixed investment project. Subsequently inflation rate in the economy slows down and the market rate of interest declines. The cash flows from the project may decline as a result of the fall in the rate of inflation but the firm is logged into high cost borrowing.
4. A fund manager expects to receive a sizable inflow of funds in three months to be invested in five –year interest rate will have declined thus reducing the return on his investments.
5. A bank has invested in a six-month loan at 18% and financed it by means of a three-month deposit at 16.5%. At the end of three months it must refinance its investment. If deposits rates go up in the mean while its margin will be reduced or may even turn negative.
6. A fund manager is holding a portfolio fixed income securities such as government and corporate bonds. Fluctuations in interest rates expose into two kinds of risks. The first is that the market value of his portfolio varies inversely with interest rates. This is the risk of capital gains or losses. Secondly he receives periodic interest payments on his holdings, which have to be reinvested. The return he can obtain on these reinvestments in uncertain.
In each of these cases, an adverse movement in interest rates hurts the firm by either increasing the cost of borrowing or by reducing the return on investment or producing capital losses on its assets portfolio. During the early 80’s investor’s preferences shifted towards floating rate instruments thus exposing borrowers to substantial interest rate risks.
For most Indian companies the idea of interest rate risk is relatively new. In an environment of administered rates and fragmented, compartmentalized capital markets, neither investors nor borrowers felt the need to worry fluctuations in interest rates.
With increasing resort to external commercial borrowings, Indian companies have had to recognize and learn to manage interest rate risk. Also, the Indian financial system is gradually moving in the direction of market determined interest rate risk.
Also, the Indian financial system is gradually moving in the direction of market determined interest rates. During the last few years the environment has changed drastically. In particular, the steep rise in interest rates during 1995-1996 has led to the painful realization that careful management of the interest rate risk is crucial to a firm’s financial health.