Interest rate risk is the risk of uncertainty of a possible loss that could arise due to movements or changes in interest rates. If interest rates rise, the value of bonds or financial assets drops and vice versa. Borrowers at fixed interest rates tend to suffer or lose when interest rates vice versa.

( 2 marks)

Ways of managing interest rate risk:
Interest rate risk can be managed using a variety of strategies. Internal strategies that may be used include the following:

• Interest matching, which involves matching the interest type on the borrowing with the interest type on the investment to be financed. For instance, an investment that will return constant cash flows is financed with a fixed-rate loan.
• Interest netting involves setting off interest receivables and interest payables to reduce the underlying exposure to a lower amount that may be hedged using external strategies.
• Interest smoothing, which involves balancing the amount of fixed-rate loans with variable-rate loans. With fairly equal proportions of fixed-rate and variable-rate loans, any movement in interest rates will bring both losses and gains of fairly equal amounts that would net off.

External strategies for managing interest rate risks include the following:

• Forward rate agreement, which involves hedging the interest rate exposure with a forward contract with a bank.
• Interest rate futures involve hedging the underlying interest rate exposure by borrowing in futures (i.e., selling futures contract) or lending in futures (i.e., buying futures contract). As a result, the entity might earn some gains from futures, which can be used to offset interest rate losses from the underlying exposure.
• Option on interest rate futures, which involves buying a right to borrow or lend in futures. This permits the entity to enjoy gains upside when the option’s strike interest rate tends to be more favourable than the futures interest rate.
• Interest rate swap, which involves swapping fixed interest payments for variable interest payments.

(Marks allocation: 1.5 marks for each of two strategies = 3 marks)

It is a hedge because the variable rate Asanka will receive will compensate the variable rate Asanka will pay to its Bankers it borrowed variable from and will be left with only the fixed interest payment. Settlement will be on net basis.
This takes off the uncertainty and volatility in monthly interest payment from Asanka.

• Liquidity preference theory: There seems to be a mismatch between the loan terms that lenders are ready to provide and the loan terms that borrowers demand. In general, lenders prefer giving short-term loans whereas borrowers prefer long-term loans. The liquidity preference theory explains that since lenders prefer short-term loans to long-term loans, they will offer short-term loans at lower rate but long-term loans at higher rates.
• Expectations theory: The yield curve depends on expected future inflation. Normally, average expected rate of inflation increases over time. Therefore, loans with longer terms are expected to provide higher inflation premium, which implies a higher interest rate, whilst loans with shorter terms may provide lower inflation premium, which implies a lower interest rate.
• The market segmentation theory: The market for funds can be segmented into two: the market for short-term funds and the market for long-term funds. According to the market segmentation theory, the yield curve could be upward sloping, flat, or downward sloping depending on the supply and demand conditions in each market. For instance, if during a period, there are fewer lenders willing to offer long-term loans but more borrowers demanding long-term loans, there will be shortage of funds in the market for long-term funds and excess fund in the market for short-term funds. Consequently, rates on long-term loans will be higher than rates on short-term loans, and the yield curve will be upward sloping.
• Government policy: Actions of the central bank in relation to management of interest rate may affect the yield on debt stocks of different maturities.

• Matching: The company would much assets and liabilities with common interest rates. That is, if an investment will yield constant payoffs then it should be financed with a loan with fixed interest rate and vice versa.
• Smoothing: The company would keep a balance between its fixed rate borrowing and floating rate borrowing.
• Forward rate agreement: The company would hedge its exposure to interest rate risk by fixing the interest rate on future short-term borrowing. This is done through an over-the-counter arrangement with a bank.
• Interest rate futures: The company would speculate on the movement of interest rate by buying/selling standardized contracts to lend/borrow at a futures rate.
• Interest rate option: The company would buy an option to obtain the right to borrow at a predetermined strike interest rate. This would allow the company to limit adverse interest rate movements while taking advantage of favourable interest movements.
• Interest rate swap: The company would agree to exchange interest rate payments with a counter party.

• Liquidity preference theory: Explains that the yield curve is likely to be upward sloping (i.e. lower yield for shorter maturities and higher yield for longer maturities) as investors prefer having cash sooner to having cash later. Therefore, investors want a higher compensation to invest in longer-term security/loans, which has much of their cash flows occurring later; and lower compensation to invest in short-term security/loans, which has much of their cash flows occurring sooner. In conclusion, the longer term interest rates tend to be higher than shorter term interest rates, and the yield curve slopes upwards.
• Expectations theory: Explains that interest rates reflect expectations of future changes in interest rates. When interest rates are expected to rise in the future, longer-term interest rates will be higher than shorter-term interest rates, and the yield curve will slope upward. When interest rates are expected to fall, shorter-term interest rates may be higher than longer-term interest rates, and the yield curve becomes downward sloping.
• Market segmentation theory: Explains that the slope of the yield curve will reflect conditions in the different segments of the market. Suppose the debt market is segmented into short-term debt market and long-term debt market. If during a period, there are few lenders who are willing to offer long-term loans but more borrowers who demand long-term loans, there will be shortage of funds in the market for long-term funds and excess fund in the market for short-term funds. Consequently, interest rates on long-term loans will be higher than rates on short-term loans, and the yield curve will be upward sloping.
• Government policy: Government may influence level of interest rate in the economy through its monetary policy. A policy with the effect of keeping interest rates relatively high may force short-term interest rates higher than long-term rates. For instance, as the Government of Ghana borrows more through the 182-day Treasury bill than the 1-year note, the annualised interest rate on the 182-day bill is higher than the annual rate on 1-year note as of August 28, 2015.

Interest rate parity is the method of predicting foreign exchange rate based on the hypothesis the different between the interest rate in two countries should offset the difference between the spot rate and the forward foreign exchange rate over the same period.

Purchasing power parity is the rate theory that states that the exchange rate between two currencies is the same in equilibrium when the purchasing power of currency is the same in each country.