How borrowers can survive higher interest rate cycles

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Interest rate futures can be used to hedge against the risk associated with changes in interest rates. PHOTO | SHUTTERSTOCK

The ever-changing interest rates slapped on credit by banks due to changes in the central bank reference rate set by the Monetary Policy Committee (MPC), continue to worry many Kenyans.

The committee reviews the Central Bank Rate (CBR), which informs how banks price their loans or mortgages from time to time.

Interest rates change over time primarily due to adjustments made by the CBK to CBR also known as the discount, benchmark, or key interest rate.

This is the interest at, which local commercial banks can borrow from the CBK, which impacts what they charge their customers. In addition, the regulator can adjust the base rate to manage economic growth and inflation.

When an economy is overheating, with rising inflation, the CBK might increase the base rate to cool down spending and borrowing leading to higher interest rates for loans and mortgages.

Conversely, in periods of economic downturn or recession, it may lower the base rate to stimulate economic activity by making borrowing cheaper, which translates into lower interest rates.

Therefore, the changing base rate is a crucial determinant of the fluctuation in interest rates over time.

This shift was prompted by the CBK’s decision on June 26 to increase the Central Bank Rate (CBR) from 9.5 percent to 10.5 percent translating to 100 basis points increase.

The MPC noted that persistent inflationary pressures, increased risks to the inflation outlook, heightened global risks, and potential impacts on the domestic economy necessitate tightening the monetary policy in Kenya.

This jump was primarily driven by fuel and food costs to 10.2 percent and non-food non-fuel prices.

When the decision was made, primarily due to the economic situation in the Kenyan market, many banks quickly reacted to this new development.

Access Bank was the first to announce a rise in loan pricing following the newly revised rates.

During the same week, Equity Bank also adjusted their new loan interest rates in response to the new CBK figure.

The way out

Financial derivatives are financial instruments whose value is got from an underlying asset or a group of assets.

These underlying entities can encompass stocks, bonds, commodities, currencies, interest rates, and market indexes.

The primary use of financial derivatives is to hedge against the risk of significant interest rate fluctuations, but they can also serve speculative purposes, particularly concerning Libor rates.

Financial derivatives manifest in various forms, each having distinct characteristics and uses. Futures are a type of financial derivative.

These contracts bind the borrower or seller to dispose of an asset, whether a tangible commodity or a financial instrument. They are unique in establishing a preset date and price for this transaction.

Secondly, there are options for contracts. An options contract provides the buyer with flexibility, granting them the right but not the obligation to buy or sell a specific underlying asset.

The precise actions that will be taken hinge on the type of contract the buyer holds.

The third type is forward contracts which are non-standardised agreements drawn between two parties. Similar to futures, it stipulates the buying or selling of an asset at a predetermined future date. However, the price is agreed upon in the present.

Lastly, swaps are another form of financial derivative contracts. In a swap, two parties, namely banks, agree to exchange financial instruments.

The instruments involved in a swap can vary, including interest rates, commodities, or foreign exchange.

Remember that using these financial derivatives does carry its risks, including that the other party could default and the risk that the hedge will not perform as expected.

Therefore, those who understand these loan products and their risks should only use such strategies.

Financial derivatives can help reduce exposure to interest rate risk by allowing businesses and individuals to manage or hedge their interest rate sensitivity.

These tools can create predictability and stability in fluctuating interest rates when properly utilised.

An interest rate swap effectively manages exposure to fluctuations by permitting an entity to exchange its position.

For instance, a Kenyan bank with a floating rate loan is vulnerable to rising charges. By engaging in an interest rate swap agreement where they receive a floating and pay a fixed interest rate, the bank effectively converts its obligation to a fixed interest rate thus remaining on a firm footing.

Interest rate futures can be used to hedge against the risk associated with changes in interest rates. If a business foresees a rise in interest rates, it can engage in short-selling interest rate futures.

If the rates rise as anticipated, the value of the futures contracts will decrease, leading to a gain that can offset the increased borrowing cost.

On the other hand, if a drop in interest rates is expected, a long position in futures can be established.

Options on interest rate futures allow the borrower to hedge against drastic movements in interest rates. Suppose a Kenyan holds an option to buy interest-rate futures (call option), and rates increase significantly.

In that case, the entity can exercise the option to buy the futures at a lower price than the current market rate, thereby profiting from the difference.

If interest rates do not change as expected, the holder's loss is limited to the price paid for the option (the premium).

Kenya ought to develop an infrastructure where these financial instruments can be developed to ensure that weathering financial storms are a problem of the past since financial derivatives can buffer against interest rate variability experienced today.

Joab Onyango Odhiambo, PhD, is a Lecturer at Meru University of Science and Technology (MUST)

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