Interest Rate Risk Explanation:

Interest rate risk is the risk of uncertainty and potential loss that could arise due to movements or changes in interest rates. If interest rates rise, the value of bonds or financial assets drops and vice versa. Borrowers at fixed interest rates tend to suffer or lose when interest rates rise, as they may face higher interest expenses on new borrowing or may find that their existing fixed-rate liabilities are now more costly compared to prevailing market rates.

Ways of Managing Interest Rate Risk:

1. Interest Rate Matching:
   • This strategy involves matching the interest type on the borrowing with the interest type on the investment to be financed. For example, an investment that will return constant cash flows can be financed with a fixed-rate loan. This ensures that the interest expenses are predictable and aligned with the cash flows generated by the investment.
2. Interest Rate Smoothing:
   • This method involves balancing the amount of fixed-rate loans with variable-rate loans. By maintaining a balanced proportion of fixed-rate and variable-rate loans, any movement in interest rates will result in both losses and gains of fairly equal amounts, which would net off. This approach reduces the volatility in interest expenses due to fluctuations in interest rates.

External Strategies:

1. Interest Rate Swap:
   • This involves swapping fixed interest payments for variable interest payments, or vice versa. By engaging in an interest rate swap, the entity can achieve a desired interest rate profile that better matches its exposure, thereby reducing the risk of adverse movements in interest rates.
2. Forward Rate Agreement (FRA):
   • An FRA involves hedging the interest rate exposure with a forward contract with a bank. This allows the entity to lock in an interest rate for a future period, thereby providing certainty over borrowing costs and mitigating the risk of interest rate fluctuations.

Marks Allocation:

• Explanation of interest rate risk: 2 marks
• Each management strategy: 1.5 marks