The era of historically low interest rates in the U.S. is over. Amidst aggressive moves from the Federal Reserve to curb inflation, businesses are facing a volatile rate environment for the first time in more than a decade. Understanding this risk and strategically managing it will be critical for businesses.
Countless factors can affect an organization’s position and risk tolerance to interest rates. Before developing a risk mitigation strategy, it’s important to understand the significant areas of risk and the tools available to manage them.
Smart Business spoke with Jim Altman, Middle Market Pennsylvania Regional Executive at Huntington Bank, about strategies to offset the challenges of a rising rate environment.
What tools are available to mitigate risks associated with interest rate volatility?
Common risk mitigation tools include interest rate swaps or a traditional fixed-rate loan. While a mixture of fixed- and floating-rate debt can make sense for some companies, every situation is different.
Hedging is fundamentally a protective strategy reflecting a company’s attitude toward risk. Hedging strategies can be used in a variety of ways to help protect against those uncertainties. For example, since there’s no financial benefit to a fixed loan if rates decrease, some companies might choose an interest rate swap to set how much floating exposure it wants. That decision will determine when to start hedging and for how long. Some companies, though, have such a tight cash flow they can’t take the chance that rates will increase, so they opt to fix their rates and take the unknown out of the equation.
Derivatives are one of the most cost-effective options for businesses to protect themselves against interest rate exposure. Interest rate derivates are hedging solutions that can minimize or eliminate risks related to rate fluctuations. Businesses can consider derivative strategies using interest rate swaps, caps or collars to limit volatility and reduce their risk profile. The unpredictable fluctuations in the market right now can have a significant impact on a company’s finances. Companies with future commitments, such as procuring equipment or constructing a new building, can turn to derivatives to fix rates at current levels rather than risk higher costs down the road.
Interest rate swaps, which enable companies to manage variable rate exposures, are an attractive solution as the benchmark rate climbs. With this type of derivative, a company can lock in a rate on all or a portion of its floating rate exposure for a specified period. Although it’s not clear exactly how high rates will rise, nor when they will stabilize, fixing a rate now is one less risk factor for businesses to worry about.
How can businesses determine how best to approach this challenge?
Volatility or unpredictability in critical business areas, such as interest rates, could be disastrous to a company. Any of the variety of approaches to managing or eliminating interest rate risk must be based on each company’s unique situation and tolerance level.
The first step is understanding how interest rates affect the company and how much risk the company is willing to take. Organizations should internally analyze their risk, then, depending on their internal expertise, consider working with an outside analyst to better understand or get more visibility into the risks that can affect their company’s position. From there, companies can structure an approach that manages that exposure while staying within a comfortable risk zone.
As the economy shifts, so do rate and risk environments. Interest rate hedging eliminates or reduces one of the many uncertainties that businesses face. It also provides certainty, allowing companies to focus on day-to-day operations that they can control or influence. The strategies a business adopts depend on their exposures and tolerance for risk. There is no one-size-fits-all approach to managing risk and adjusting to today’s rising rate environment. That’s why it’s important to carefully weigh all the factors, and consult with experts, before committing to a strategy. ●
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