Interest rate guarantees (IRGs)

Interest rate guarantees (IRGs) are options on Forward Rate Agreements (FRAs) and are a tool for hedging interest rate risk.

Characteristics

An interest rate guarantee (IRG) is an option on an FRA and, like all options, protects the company from adverse movements and allows it take advantage of favourable movements.

Call or put?

If borrowing money, a firm would buy an FRA (explained above), so a call option over FRAs would be used. Similarly a put option over FRAs would be used to cover a deposit.

IRGs are usually written by banks and other financial houses (i.e. the same organisations that may offer FRAs).

Decision rules

• IRGs are more expensive than the FRAs as one has to pay for the flexibility to be able to take advantage of a favourable movement.

Illustration

Harry Inc wishes to borrow $8m in two months' time for a period of three months.

An IRG is available at 5% for a premium of 0.1% of the size of the loan.

Calculate the interest payable if in two months' time the market rate is:
(a) 7% or (b) 4%.

Solution

Note: There is no need to time apportion the premium percentage.

When to hedge using FRAs or IRGs

If the company treasurer believes that interest rates will rise, will he use an FRA or an IRG? He will use an FRA, as it is the cheaper way to hedge against the potential adverse movement.

If the treasurer is unsure which way interest rates will move he may be willing to use the more expensive IRG to be able to benefit from a potential fall in interest rates.

Rating :	Ratings & Comments  (Click the stars to rate the page)

Tags:	interest rate guaranteee;IRG;FRA;interest rate risk