An interest-rate game plan.

• Author: Marks, Ronald D.
• Position: Risk Management

As unpredictable as they may be, interest rates can be tamed--if you keep your financial toolbox full and you stick to a clear risk-management plan.

While the dramatic decline in interest rates was a welcome relief to most financial executives, the task of managing rate risk is never complete. Indeed, the next move in interest rates is always uncertain, so you have to develop a game plan not only for your future financing needs but also for your projected interest-rate costs. Yet, financing plans, like rate forecasts, usually change, so your strategy must be dynamic and flexible.

If you fixed your term debt as a way to insulate yourself from rate risk, the plunge in rates over recent years clearly shows you need to manage rate risk in both directions--on the way up and on the way down. In today's competitive business arena, your performance is under continual review, requiring a nimble treasury strategy. But one way you can protect yourself from interest rate risk is to arrange some of your options along a spectrum.

By doing so, you, rather than your banker, can decide the framework of the financing for your firm, given your unique business situation and the interest-rate outlook. The spectrum includes choices other than the traditional fixed- or floating-rate options, depending on how you expect interest rates to move in the future and your loan prepayment inclinations. The chart on page 40 shows how these two key decision variables for term financing structures allow you, as a corporate borrower, to accurately pinpoint the hedging strategy that's right for you.

As you can see, the traditional fixed- and floating-rate options are at opposite ends of the continuum. Clearly, if you're firmly convinced that interest rates will move a particular way during your borrowing period and you have a definite idea of whether you'll prepay your loan, then these two traditional options will meet your needs. However, if you're uncertain about interest-rate movement or the possibility of your prepaying the loan, then one of the other options would better match your needs.

For example, the swap is a widely accepted method of converting floating-rate loans to fixed rates. This alternative offers you protection against rising rates with future flexibility to convert back to other financing options with a less onerous prepayment penalty than the traditional fixed-rate loan.

Another option, called LOWAR, or Lower One-Way Adjustable Rate, acts like a fixed rate if rates move higher, because the starting rate, which is slightly higher than the traditional fixed rate, is the highest rate ever paid. But, if rates fall, the LOWAR rate will adjust lower, similar to a conventional floating rate. Prepayment penalties under this option are moderated as well.

The floating rate with a cap offers the prepayment flexibility of a floating rate but with the protection of a maximum rate, or a cap. This option is really customized rate risk "insurance," which you purchase with an up-front premium determined by the related capped rate, the coverage period and a market volatility factor.

WITH DICTIONARY IN HAND

Interest-Rate Sensitivity--The three middle options on the chart come from the evolving market of modern hedging techniques, in which interest-rate swaps and caps are...