Question

Choat and Sons Limited is a company based in reading in the south of england. The company specializes in the production of forklifts both for domestic market and for export mainly to the USA. Due to increased demand for the company's products, it has become necessary to expand its production facilities.

Choat and Sons Limited intends to borrow £1,500,000 in three months time for a period of three months but expects interest rates to rise above the current 6% to more than 11%. Management of the company is worried about the expected future interest rises and wants to insulate the company from interest rate risk.

Required;

1. What is interest rate risk? Explain two types of interest rate risk that companies may be exposed to.

Answer 1

Interest rate risk is the risk of increase in liability/expense due to potential increase in the interest rates.

For example from above situation it is evident that the present interest rate is 6%. Now, it may increase to 11% or more this is known as risk, where by there will be increase in the interest payment.

Two types of interest rate risks are,

1. Repricing risk: It is the risk of changes in the interest rates.

2. Risk from hedging, where there is a chance of potential loss from the hedge due to the interest rates.