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Hedging Interest Rate using Smoothing

Hedging Interest Rate using Smoothing

When taking out a loan or depositing money, businesses will often have a choice of variable or fixed rates of interest. Variable rates are sometimes known as floating rates and they are usually set with reference to a benchmark such as LIBOR, the London Interbank Offered Rate. For example, variable rate might be set at LIBOR +3%.

In this simple approach to interest rate risk management the loans or deposits are simply divided so that some are fixed rate and some are variable rate. Looking at borrowings, if interest rates rise, only the variable rate loans will cost more and this will have less impact than if all borrowings had been at variable rate. Deposits can be similarly smoothed.

There is no particular science about this. The business would look at what it could afford, its assessment of interest rate movements and divide its loans or deposits as it thought best.

Source: Ken Garrett, ACCA

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