Businesses could look to interest rate hedging as rates rise

To prevent rising interest rates from taking a bite out of the bottom line, your peers could be considering an interest rate hedging strategy in order to keep the rates low on variable-rate business loans and stabilize cash flow.

Because higher interest rates increase the cost of borrowing money, it can result in postponement of borrowing or harder-to-come-by credit, which can lead to sluggish corporate growth and decreased profits.

According to Farah Lotia, the director of interest rate and quantitative analytics at the risk management advisory company Hedge Trackers, the mindset of many CFOs and corporate treasurer teams historically was that hedging was unnecessary. But that thinking is starting to change.

With reports of the Fed mulling increasing interest rate hikes anywhere from .75%, to 1%, currency and commodity market volatility, and fears of stagflation/recession, Lotia said that for CFOs, this is like a wake-up-call doctor visit with orders to start an exercise program because of high cholesterol.

“I have a client who had a huge fight with the board and tried to convince them to hedge. And they locked into a sub-2% rate on their seven-year financing a couple of years ago. This was the pandemic time – rates were the lowest they’ve ever been, and the board said: ‘This doesn’t make sense. Why are you hedging?’,” she said in a Zoom call.

“That should be the premise of hedging – in the good times and the bad times – to keep at it,” Lotia continued. “Because the fact is (the bad times) happen when you least expect them.”

Approaches to interest rate hedging

Because interest rate hedging can remove uncertainty, Lotia compared choosing a hedging product to choosing an insurance policy. And just like an insurance policy or an investment portfolio, your hedging program will be complex and not one-size-fits-all.

Your ideal interest rate hedging partner will be one that asks about your organization’s specific, long-term needs and growth patterns, financial situation, risk tolerance and financing maturity duration to recommend a customized solution. The partner you choose should explain all risks involved and may suggest a diversified portfolio that blends rates, with a mix of:

• forwards
• forward rate agreements
• futures
• swaps
• options
• swaptions
• embedded options
• caps
• floors, and
• collars.

Every sound hedge program should have key accounting, trading and reporting controls. Before entering an agreement, ask your hedge program partner what controls are in place and how they work.