How Banks Mitigate Risk Of A Loan By Using An Interest Rate Hedge

Financial organizations such as banks that regularly make loans to customers can have exposure to risk from modifications to interest rates. Anytime an interest rate floats or can adjust based on the market or index, this is a potential issue for banking institutes when the rate is not set at a fixed rate. When the value of a loan adjusts due to interest rates it can be hard for a bank to assess the value the loan. When a bank carries a rather substantial portfolio of loans whose value is not fixed, the problem is therefore compounded both negatively or positively. Since the value of a bank’s loan portfolio might be at risk, the bank may want to make an interest rate hedge, or to find a way to minimize the change in value of the loans it makes.

Entering into particular contracts with its borrowers allows the bank to create an interest hedge which safeguards them from loss. An interest rate cap is just one such contract type. Not only requiring a fee from the borrower, this will cap or set a ceiling on the amount of interest that a borrower will pay. For instance, the borrower can be shielded from a rise in interest rate should a floating interest rate on the loan states that it can not exceed above 8 percent, meaning the borrower has a specific cap, ensuring they will always be able to afford their loan as it ages.

Accepting a contract where there is an interest rate floor, conversely can ensure the lowest rate available on interest rates is quite possible. This is another way that a bank can hedge its interest rate financial risk. Even if the market dictates that the interest on a loan should drop to 3.5 percent, if the borrower has consented to an interest rate floor of 5 percent, the borrower will pay the rate which is higher.

In certain cases a borrower might choose what is called an interest rate collar. This is just a combination of an interest rate cap as well as an interest rate floor. Interest rates for any loan are set using a top and bottom number it can not exceed or go below for the duration of the loan. These types of agreements are often without a cost because the fee a borrower might pay for the cap might be equal to the benefit it might receive for the floor.

Another way a bank can hedge the risk of interest rate modifications on a loan is to allow a borrower to initiate an interest rate swap. A swap allows a borrower to transform the floating interest rate on its loan to a fixed rate or one that doesn’t modify with the market. Any expenses associated with the swap can be integrated into the rate change.

Banks can additionally enter into contracts with their borrowers in what is referred to as forwards. A forward is actually an agreement that something will happen in the foreseeable future. Balloon payments is one illustration of a forward, in which the loan could have a large amount due at the end of the loan. Locking into a fixed rate is possible this way even if the borrower plans to renew the life of the loan. It is deemed a forward as the locked in interest rate is not going to go into effect until a future date.

These are just a few examples how a lending institution protect themselves when entering into just about any loan as the interest rate hedge will ensure the value of their portfolio is certain to always be in their favor.