The Interest Rate Risk Can Be Managed, Too

Economic processes nowadays are characterized more than ever before by rapid development and instability, the latter of which being the result of the risks entailed by any economic activity. Such risks are numerous and have been touched in many researches and lectures. The role of this article is to warn about the risk of financing an economic activity. The factors determining this type of risk are numerous, being derived from the instability of the macro-economy, with direct effects on the exchange rate and the interest rates.

The volume of loans given to companies and individuals is now much greater than it was in 2007 and the trend will continue, despite temporary lending difficulties. The certainty is that the cost paid by companies and individuals for their loans is increasingly higher, because of either interest rate increase and volatility, or the devaluation of the leu against forex.

Very few know that they can protect themselves against exchange rate fluctuation through something called exchange rate hedging, and also against interest rates fluctuations, through swap contracts. Banks currently offer loans with either a fixed interest rate or a variable interest rate. The latter is calculated by adding percentage points to the interbank exchange rate, which varies from one interval to the next and is a function of time. So most of the loans are dependant upon BUBOR, LIBOR, EURIBOR and/or ROBOR. The corporate or individual borrower can obtain financing with costs that are predetermined upon the beginning of the loan, which are reversely linked to the costs of the loans taken from the spot banking market.

Moreover, the statistics included in the monthly bulletin issued by the National Bank of Romania for October 2008, the cost of lending has increased considerably. The average interest rate for RON denominated loans up to 1 million EUR in RON equivalent issued to companies increased from 16.08% in September to 19.41% in October. Moreover, the average interest rate for RON-denominated loans above 1 million EUR issued to companies increased from 15.01% to 19.96% in the same interval.

Considering that, at the time when financing is obtained, the risk generated by the loan is increasing (between October and November 2008, the overall cost of a loan to an individual - both consumer loans and mortgage loans - increased by 0.2-5%), the management of such risk becomes a must. Such risk management can be achieved via interest rate swap contracts.

Such contracts enable the disbursement / receipt of a loan at a future date for a fixed interest rate. Unfortunately, swap contracts on interest rates are only available to banks, via the OTC. Alternatively, players can turn to the BUBOR-3M contract available on the Sibiu Monetary & Commodities Exchange. The Sibex team is commendable for offering this type of a financial instrument to companies and individuals.

Let"s see a succinct example of lending risk management: a company is about to take a 12-month loan with a variable interest rate of 17.04%. In order to mitigate the risk of fluctuations in an interest rate linked to ROBOR, the company will buy an interest rate swap contract with a 12-month maturity and an interest rate of 17.04% and thus freeze the interest rate at 17.04%. If the interest rate on their loan increases, the company in question will lose money on their monthly payment to the bank and win money from the increase in the value of the swap contract.

The market is now highly volatile, for both the exchange rate and the interest rates so it may be opportune to have market-makers for interest rate swap contracts not only for BUBOR-3M, but also for ROBOR or LIBOR, or any other indexes stated in lending contracts. As an example, ROBOR-1W was 14.40% in October 2008, compared to 12.20% in September or 7.7% in early 2008. With a little imagination, other types of interest rate swap contracts could be created, as their development potential is almost unlimited. The only problem is the absence of market makers and their connection to the interbank market.

Even if the problems remain in place, it is important that knowledge of various types of operations is popularized. More importantly, so should be the knowledge that lending risks can be managed much better by both companies and individuals, through interest rate swap contracts.