What is Interest?
Interest is the sum of money payable on borrowing loans to finance business operations and satisfaction of needs.
Interest payable is expense for borrower while income for lender of loan finance.
Interest rate can be fixed or variable.
Fixed Interest Rate
Fixed interest rate is the constant sum of money payable during the period covered by loan finance.
Variable Interest Rate
Variable interest rate is the sum of money payable based on market interest rate when interest becomes due.
What is Interest Rate Risk?
Interest rate risk is the risk that interest rate movement will reduce profitability (Profit before tax) of the business.
Interest rate risk is different from risk arises due to higher levels of financial gearing.
Types of Interest Rate Risk
Variable Interest Rate Risk
Variable interest rate changes from time to time according to market conditions.
Variable interest rate exposes business to additional risk of interest rate movement. Rise in interest rate can erode profit before tax.
Business having volatile cash inflows should borrow loan on variable interest rate. Therefore, increase or decrease in revenue can be matched by increase or decrease in interest expense respectively.
Fixed Interest Rate Risk
Fixed interest rate remains constant for period up to maturity of loan or investment.
If business is considering borrowing loan in future, then there is risk, that interest rate will increase at the time of borrowing.
Similarly, if an business is considering an investment in interest bearing security in future, then there is a risk that interest rate will decrease at the time of purchase.
In addition, business having even cash flows should consider borrowing loan at fixed interest rate. Therefore, constant stream of revenue can be matched by constant stream of interest expense.
Basis Risk
100% effective hedging is difficult through matching because of difference in interest rates for lending and borrowing.
Difference in exchange rate can arise due to basis for determining internet rate movement.
Negative Gap
Negative gap occurs when business has more financial liabilities than financial assets having same maturity date. Excess of financial liabilities represents negative gap exposure to the business.
Positive Gap
Positive gap occurs when business has more financial assets than financial liabilities having same maturity date. Excess of financial asset represents positive gap exposure to the business.
