Matching and Smoothing
Businesses generally have the option of choosing between variable and fixed interest rates when taking out a loan or depositing money. Variable rates, also known as floating rates, are determined by comparing them to a benchmark, such as SONIA, the Sterling Overnight Index Average. For example, the variable rate could be set at SONIA +3%.
There is no chance of interest rate hikes if fixed rates are available: a $2 million loan with a set interest rate of 5% per year will cost $100,000 per year. Although a fixed-interest loan protects a firm from interest rate hikes, it does not allow the business to benefit from interest rate drops, and a business may find itself trapped in high interest costs when interest rates fall.
Smoothing
In this straightforward method to interest rate risk management, loans or deposits are simply separated into fixed and variable rate categories. In terms of borrowings, if interest rates rise, only variable rate loans will cost more, having a less impact than if all borrowings were variable rate. Deposits can also be smoothed out in the same way.
This has nothing to do with science. The company would consider what it could afford, its appraisal of interest rate fluctuations, and how best to divide its loans or deposits.
Matching
This strategy necessitates that a company's assets and liabilities have the same interest rate. The lower the difference between the two figures, the better.
Let's say the deposit rate is SONIA + 1% and the borrowing rate is SONIA + 4%, and $500,000 is deposited and $520,000 is borrowed. Assume SONIA's current market share is 3%.
Currently:
$520,000 x (3 + 4)/100 = $36,400 in annual interest paid
$500,000 x (3 + 1)/100 = $20,000 in annual interest received
The total cost is $16,400.
Assume that SONIA rises from 2% to 5% in the next year.
New interest rates are as follows:
$520,000 x (5 + 4)/100 = $46,800 in annual interest paid
$500,000 x (5 + 1)/100 = $30,000 in annual interest collected
The total cost is $16,800.
Management of assets and liabilities
This refers to the lengths of time that loans (liabilities) and deposits (assets) are held. The challenges raised aren't limited to variable rate arrangements; a corporation can run into problems if certain amounts are subject to fixed interest rates or earnings that mature at different times.
Consider the case of a firm that takes out a ten-year mortgage on a new property at a fixed rate of 6% per year. The property is then rented out for five years at an annual yield of 8%. Everything is well for the first five years, but then a new lease must be arranged. The corporation will begin to lose money if rental yields fall below 5% per year.
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