Ways to Hedge Interest Rate Risk

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Many investors, particularly those who have taken out large loans, stand to lose a significant amount of money if the interest rate rises above a certain point. Similarly, lenders may stand to lose money if the interest rate drops precipitously. For this reasons, these investors may seek to protect themselves against steep rises or falls in interest rate by "hedging" this risk using a number of financial products.

Cap

Borrowers can provide themselves a form of insurance by purchasing a financial derivative called a "cap." A party selling a cap agrees to pay the interest on an adjustable-rate loan after the interest rate exceeds a certain percentage. For example, if a borrower purchased a cap at 5 percent and the interest rate rose to 7 percent, the seller of the cap would have to pay two points of interest on the loan.

Floor

A floor functions similarly to a cap. Usually purchased by lenders, the seller of a floor provides insurance to its buyer by agreeing to cover him if the interest rate on an adjustable-rate loan falls below a certain price. For example, if a lender purchased a floor at 3 percent and the interest rate dropped to 2 percent, the floor's seller would pay its buyer one point of interest on the loan.

Collar

A collar is a combination of a floor and a cap that hedges an investor's bet by insulating her from changes in the interest rate, either up or down. A lender using a cap will generally purchase a floor and sell a cap, while a borrower will sell a floor and purchase a cap. Collars are advantageous because they pay for themselves; however, in exchange, the investor limits the amount of his potential gains.

Swaps

A swap is a financial derivative in which one investor trades payments derived from interest on a loan for another investor's regular payments of cash. The interest rate payments are generally pegged to an index, while the cash payments are fixed. In this way, an investor can essentially sell profits from the interest rate to another investor, causing him to take on the risks of severe fluctuations. Swaps can also be structured so that one interest rate is traded for another.

Futures

Like futures contracts on a commodities exchange, interest rate futures can be purchased by investors seeking to hedge their risk to interest rates by locking in a future price on rates. Some futures are purchased directly, while others are sold only as options, giving the investor the option, but not the obligation, to purchase a hedge on the rate.

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