Investment Optimization

With the fluctuations in interest rates shown in recent years, investors in interest rate products and lenders who pay interest on their loans have discovered that there are risks attached to their investments/liabilities which they have not always anticipated. Some large losses were suffered due to the movements in interest rates. This resulted in specialized interest rate derivatives being created in the market to hedge the risk of large financial losses due to movements in interest rates. These derivatives, although developed to manage the risk of interest rate fluctuations, can also in certain circumstances be used to hedge other risks, such as price risks.

With PSS’s interest optimizations, clients will benefit from improved margins for maintaining balances. This service does not encompass the physical movement of funds between accounts so the clients benefit from reduced transaction and FX charges, as well as from avoiding any additional workload for their back office.

Those seeking to optimize treasury without actually carrying out transfers of liquidity can use PSS’s comprehensive notional pooling services where individual account balances can be brought together on a purely notional basis in order to calculate interest.

Among your choices, Private Scandinavian Sparkasse Investment Bank offers the three most efficient methods in securing interest optimization as follows:

  • Forward Rate Agreement
  • Interest Rate Floor
  • Interest Rate Swap

PSS’s FRA (Forward Rate Agreement)

  • the cash settled forward contract on interest rate that is used by large banks and corporations to hedge future interest rate exposure.
  • Under this agreement, the borrower (buyer) and the lender (seller) agree to pay each other the interest difference between the agreed-upon rate (the Fixed Rate) and the actual interest rate on the future date (the Floating Rate).

An FRA will have two interest rate in the contract:

Interest RateDescription
Fixed Rate
  • The rate the buyer will pay to the seller on a specified loan.
  • The buyer fixes the interest rate that he will pay on a loan.
Floating Rate
  • The rate that the seller will pay to the buyer on a specified loan.
  • The seller can convert his fixed rate loans to a floating rate loan, and gain from a fall in interest rates.

How Forward Rate Agreement Works?

Suppose the current month is May

There are two scenarios that possibly occurs when company A agrees on the agreement with PSS.

If the Floating Rate on June is at 7 percent, which exceeds the Fixed Rate

If the Floating Rate on June is at 5 percent, which is lower than the Fixed Rate

Using FRAs is seen to be a win-win situation, since at maturity, only the difference between contracted interest rate and the market is being exchanged, and no funds exchange occurs.

PSS’s Interest Rate Floor

  • a contractual agreement on the lowest acceptable interest rate with regards to a reference interest rate for a specific period and an agreed volume.
  • an agreement that were designed for investors to hedge against decreasing interest rates.

How Interest Rate Floor Works?

Suppose the current month is May

If the Floating Rate in May is at 5 percent, which is lower than Interest Rate Floor at 7%, then the difference below the interested rate in IRF agreement are paid to the buyer.

In Interest Rate Floor agreement, only the difference between contracted interest rate and the market is being exchanged, and no funds exchange occurs at maturity.

Interest Rate Swap

An interest rate swap is an agreement between two parties to swap a fixed rate and a floating rate paid on loans of a certain notional principal for a certain period.

Instance:

If a company pays a floating rate on a loan, and the company is of the opinion that the market rates and the floating rate will increase, it could swap its floating rate with another company paying a fixed rate on a loan but with a different opinion about interest rates. In the case of an interest rate swap (as with an FRA), both parties are exposed to the upside (interest rates moving as anticipated) and the downside (interest rates moving in the opposite direction from the anticipated direction).

How does an interest rate swap agreement work?

No exchange of principal amounts takes place. The agreement will stipulate:

  • a floating rate, which will be paid by one party to the other
  • a fixed rate, paid in the opposite direction
  • the term of the agreement
  • the dates at which recalculations will be made in terms of the difference between
  • the fixed and floating rates (called reset dates)

The swapping of interest rates is commonly used by hedge funds and investors who project the change in interest rates. Interest rate swap is a popular method of arbitrage due to the varying levels of company credibility resulting to a positive quality spread differential. In addition to that, interest rate swapping limits or manages the exposure to fluctuations in interest rates and obtains marginally lower interest rates.