Hedging Strategies
Risk of interest rate movement can be controlled by hedging.
Interest rate is hedged by creating risk in opposite direction. If interest payment is required, then business should create interest income by investing in interest bearing securities. If interest income is expected, then business should create interest payment by borrowing loan.
Matching
Business can match financial assets with financial liabilities to offset interest income on financial assets with interest expense on financial liabilities.
Matching is useful for hedging interest rate movement as increase or decrease in interest expense (liabilities) will be cancelled by decrease or increase in interest income (asset) respectively.
For effective (100%) hedge of funds, matching should meet the following conditions.
- Maturity date of financial asset and financial liability should be same.
- Rate of interest receivable and payable should be same.
- Financial asset and financial liability should be in same currency.
Matching is internal hedging strategy; therefore, it saves transaction cost of hedging externally.
100% hedge does not mean hedging of all interest rate rate risk. Business may have excess of financial assets over financial liabilities or excess of financial liabilities over financial assets. Excess financial assets or liabilities need to be hedged using other hedging strategies or techniques.
Smoothing
Smoothing is keeping balance between borrowings having fixed and variable rate of interest. It will not eliminate risk but it will reduce the risk to a level acceptable by the business.
Benefit of using hedging strategies is the elimination of uncertainty regarding future interest rate movement at planning stage.
Hedging strategies does not cover the risk of loss in competitive position due to movement of interest rate in the favour of competitors.
