What Is Interest Rate Risk & How to Hedge Against It

Inflation is making headlines, and the Fed is raising interest rates to combat it. Still, what does it all mean for your business? If you rely on loans or lines of credit, those rising rates could substantially increase your payments, squeezing your margins and leaving you with less cash to grow.

Fortunately, there is a solution. According to BIS, businesses that hedge their interest rate risk experience a less negative impact on their financial health and overall valuation.

This article will explain everything about interest rate risk, including what it is, what influences it, and how to hedge against this risk.

Without further ado, let’s dive right in.

Interest rate risk is the possibility that changes in interest rates will negatively impact your business finances.

Suppose you have a floating-rate loan. The interest you pay moves along with market rates. When those rates go up, so do your monthly repayments. This can quickly drain your cash reserves and limit your ability to invest in your business’s growth or even cover day-to-day expenses.

Not only your loan but also your customers. If borrowing is more expensive, they might cut back on spending, which in turn hurts your sales. Moreover, if you’ve invested in bonds, their value will drop as interest rates rise, adding another layer of financial pressure.

Understanding the factors that impact your specific interest rate risk exposure is crucial for developing effective mitigation strategies. These factors include:

Your company's creditworthiness, as indicated by your credit rating and debt-to-equity ratio, affects the interest rates you'll receive. A higher credit risk generally means higher interest rates. This is because lenders perceive you as a riskier borrower, so they charge more to compensate for the potential that you might not be able to repay the debt.

In addition to higher initial rates, businesses with lower creditworthiness are also more vulnerable to interest rate fluctuations. When interest rates rise, these businesses are often hit harder, as lenders may further increase their rates or tighten their lending standards.

The length and terms of your loans are critical factors. Longer-term loans with variable rates (or floating rates) expose you to greater risk over time. In contrast, fixed-rate loans offer more stability and predictability, as your interest payments remain constant regardless of market fluctuations. However, they might come with a slightly higher initial interest rate compared to variable-rate loans.

The broader economic environment and market volatility can greatly impact your interest rate risk exposure. During economic downturns, lenders may become more risk-averse and tighten their lending standards, making it harder for businesses to refinance or secure new loans. This can leave your business more vulnerable to rising interest rates.

Also, market volatility can lead to sudden and dramatic fluctuations in interest rates, making it difficult to predict future borrowing costs and plan accordingly. This uncertainty creates challenges for budgeting, cash flow management, and overall financial stability.

If your business has any debt in a foreign currency, you face an additional layer of interest rate risk due to exchange rate volatility. Let's say you have a loan in EUR. If the EUR weakens relative to the U.S. dollar, you'll need more USD to repay the same amount of Euros. So your interest rate increases, even if the official loan rate stays the same.

Before you can manage interest rate risk, you need a clear picture of how your business is affected.

Begin by making a list of all your business debts, including loans, lines of credit, and any other outstanding obligations. For each debt, note the following details:

• Interest Rate Type: Is it fixed or float? Floating-rate loans are directly impacted by changes in market interest rates, while fixed-rate loans remain constant.
• How Much You Owe: Knowing your total debt helps gauge your overall risk.
• Maturity Date: Understanding when each debt is due allows you to anticipate when you might need to refinance or repay at potentially higher rates.
• Payment Schedule: Are payments monthly, quarterly, or annually? This is key for managing your cash flow.

Interest-sensitive assets are financial holdings whose value can fluctuate with changes in interest rates. Examples include:

• Cash: While cash itself doesn't change in value, its purchasing power can shrink over time due to inflation, which often goes hand in hand with higher interest rates.
• Accounts Receivable: If you offer credit terms to customers, changes in interest rates can affect their ability to pay on time.
• Inventory: Inventory costs can go up when interest rates rise, especially if you're borrowing money to keep items in stock.

Investments: Fixed-income investments (e.g., bonds) are particularly sensitive to interest rate changes. As rates rise, bond prices fall.

Now that you've identified your interest rate risks let's quantify them. Estimating the potential impact of rising interest rates on your business is essential for planning and risk mitigation. There are a few ways to approach this:

1. Simple Calculations

This is the most basic method. You can calculate how much your interest payments would increase if rates rose by a certain percentage. For example, if you have a USD 100,000 loan with a 5% variable interest rate, a 1% increase in rates would raise your annual interest payments by USD 1,000. Don't forget to factor in any potential changes to your business's revenue due to higher borrowing costs. This can give you a rough idea of the potential financial impact.

1. Stress Test Your Business

Imagine a worst-case scenario – a significant jump in interest rates (e.g., 3%). This is your chance to assess your business's resilience.

• How much higher could your debt payments become?
• Would you be able to maintain your cash flow and profitability?

Answering these questions can help you develop a plan to mitigate the impact of rising rates.

Hedging is a risk management technique that involves using financial instruments to offset potential losses from adverse interest rate movements. It can help businesses protect their profits and cash flow by reducing their exposure to interest rate fluctuations. Below are common interest rate derivatives you should consider.

The most widely used interest rate hedge. It helps exchange a variable interest rate on a loan or investment for a fixed rate. Imagine you have a loan with an interest rate tied to the market; it fluctuates with changes in benchmark rates.

An interest rate swap allows you to switch to a fixed rate, ensuring your payments remain constant even if market rates rise. It provides stability and predictability, essential for financial planning.

This tool sets a maximum limit on the interest rate you'll pay on a variable-rate loan. If market rates rise above the cap, you're protected from those increases. While you still benefit from falling rates, you won't be caught off guard by sudden spikes.

Collars combine the features of a cap and a floor. An interest rate collar sets both an upper and lower limit on your interest rate. This means you're protected from both excessively high and low rates. This option offers flexibility and can be less expensive than a cap alone, but it does limit your potential gains if rates drop significantly.

Not only derivatives but proactive financial management can also help you prepare for rising rates.

If you have existing variable-rate loans, consider refinancing them into fixed-rate loans. By doing this before rates climb higher, you can lock in a lower rate for the remainder of the loan term. This offers long-term stability and protection against future rate increases. However, it's important to compare the costs of refinancing (such as closing costs and fees) with the potential savings from a lower interest rate to ensure it's a financially sound decision.

If your business has multiple debts with varying interest rates, consolidating them into a single loan can simplify your payments and potentially lower your overall interest rate. This not only makes it easier to manage your debt but also can lead to significant savings over time, especially when interest rates are on the rise.

Maintaining a healthy cash reserve is essential for any business, especially in a rising rate environment. Having a financial cushion allows you to absorb unexpected costs, including higher interest expenses, and maintain financial stability.

Moreover, a cash reserve allows you to capitalize on opportunities, such as investing in new equipment or expanding your operations, without having to rely on more expensive borrowing. This provides peace of mind and ensures your business can continue operating smoothly even if revenue drops or expenses increase due to rising rates.

Hedging involves a trade-off. You're sacrificing the potential to benefit if rates fall in exchange for protection. It's crucial to weigh the costs and benefits and seek expert guidance if needed, so you can navigate this turbulent time.