Question

Why might a lending institution want to protect itself from adverse movements in interest rates? Explain

Answer 1

A lending institution may have a part of its loans as floating-rate loans. The interest paid by borrowers on these loans is linked to a base reference rate, which changes with market conditions. Thus, a fall in the market interest rate can be an adverse movement for the lending institution because its interest income will fall. The lending institution would seek to protect itself from a fall in interest rates.

Further, the lending institution may be financing its loans by taking deposits from depositors. If the interest paid on these deposits is linked to the market interest rate (the deposits are floating-rate deposits), any increase in the market interest rate would cause a rise in the interest expense. In this case, the lending institution would seek to protect itself from a rise in interest rates.