Alex Fopiano of Massachusetts is a treasury analyst who oversees various portfolios and investments. As a financial industry professional, Alex Fopiano discusses below interest rate derivatives in banking, in both the US and foreign countries.
Interest rate derivatives are those based on a single interest rate or group of interest rates. The underlying asset can be anything from commodities to stocks to bonds to metals to more. But the specific interest rate depends on the pre-agreed contract and can include the Fed funds rate, domestic interbank rates, or LIBOR.
Alex Fopiano of Massachusetts explains that banks tend to adjust lending and deposit rates based on the ever-altering interest rates seen in the market. But that isn’t always the case. Only a handful of variable interest loans are available without a unitary benchmark for interest.
Most countries observe the floating rate when calculating the lending rate to minimize the risks associated with interest rates. But in Bangladesh, for example, there isn’t a true floating rate says Alex Fopiano. Instead, banks offer consumers fixed rates under conditions that transparently state such rates are subject to changes.
Thus, banks in the country can amend interest rates whenever they consider it necessary. Generally speaking, the technique is utilized throughout the Bangladeshi system to reduce interest rate risk.
Interest Rate Minimization Techniques in Developing Countries
Bank’s treasury departments in Bangladesh practice various techniques to measure the impact of interest rate risk, including:
- Rate-sensitive gap analysis
- Duration gap analysis
- Fund transfer pricing analysis
Duration and rate-sensitive gap analysis are the most commonly used by the country’s banks. However, Alex Fopiano of Massachusetts says that fund transfer pricing maintains its importance.
The banks utilize analysis results to earn how to minimize interest rate risk. That said, they’re only beneficial if sufficient management products are available at the time.
Throughout the country, there aren’t many interest rate derivative deals since they’re yet to maximize the benefits of such products.
Bangladesh’s Derivative Market
Alex Fopiano of Massachusetts says that the country has an ultra-shallow derivative market.
Forward and SWAP (foreign exchange derivatives) are available, which banks use to reduce their forex risk exposure. And a few regulations exist relating to commodity derivatives; however, the interest rate derivative could be classed as “near nonexistent.”
The central bank published guidelines on the interest rate and forex derivative products inside its Foreign Exchange Risk Management Guideline. However, interest rate derivative products aren’t widely accepted — instead, they’re subject to a case-by-case approval process.
How US Banks Use Interest Rate Derivatives to Minimize Risks
Essentially, banks across the United States of America utilize financial derivatives to purchase protection for themselves. In other words, Alex Fopiano of Massachusetts explains that they use it to hedge and reduce risks involved with their operations.
For instance, a bank’s portfolio may open loss vulnerabilities from fluctuations in interest rates. Therefore, it buys an interest-rate derivative to keep it safe.
A pension fund can purchase protection against credit defaults in the same manner.
Every derivative transaction (regardless of the underlying asset type) has two sides. One entity (i.e., the bank) wants risk protection, and the other party takes on the risk for a price.
Banks Offer and Utilize Various Derivative Products to Hedge Against Interest Rate Risks
Alex Fopiano says that protection against interest risks is the ultimate goal for wealth accumulation and investment strategies. While there’s always the option to do nothing at all, that simply isn’t wise — as any financial institution or established investor knows.
So, various products exist that both banks and traders use to hedge against interest risks, including:
It’s the most basic management product designed to protect against interest rate risks. Put simply, it’s an agreement that solidifies a selling price for a pre-defined future date, regardless of market conditions.
Forward Rate Agreements (FRAs)
This agreement is rooted in the standard forward contract, except the gain or loss is determined as an interest rate.
Under FRAs, one entity pays a fixed interest rate, receiving a floating rate equivalent to the reference rate. Actual payments are figured out depending on the national principal amount.
Effectually, Alex Fopiano explains that the “loser” pays the “winner.”
Futures contracts are like forward contracts. However, they offer less risk by reducing liquidity and default risk.
As the name suggests, swaps are exchanges according to Alex Fopiano of Massachusetts. Interest rate swaps appear to be an amalgamation of FRAs and include an agreement between parties to “swap” sets of cash flows in the future.
Most contracts are deemed “plain vanilla swaps,” wherein one party pays a fixed interest rate and gets a floating on, and the other does the inverse.
The Bottom Line — Interest Rate Derivatives in Banking Mitigates Risks