Fluctuations in interest rate is a major concern to entrepreneurs and business executives. It has been observed that interest rate on loans vary according to the term of the loan. Besides, interest rates vary over time for varied reasons.
Required:
i) Explain THREE (3) reasons why interest rates on loans may differ for different maturities as explained by the term structure of interest rate. (6 marks)
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- 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.
ii) Suggest FOUR (4) ways of hedging the company’s exposure to interest rate risk. (4 marks)
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- 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.