Interest Rate Risk and Traditional Hedging

A company that borrows at a rate that changes with the market does not know what its interest bill will be. A company that borrows at a fixed rate knows its bill but may find itself paying more than its competitors if rates fall. An investor holding a fixed-rate bond finds its price falling when market rates rise.

A bank that lends long and borrows short can see its margin disappear when short rates go up. All of these are interest rate risk, and in a country such as Nigeria where the policy rate has moved from 26.5% to 23% in a single year, it is a practical matter and not a textbook one.

The aim of managing it is not to get the lowest possible interest cost, which depends on a forecast that cannot be made reliably, but to limit the uncertainty so that the business can plan.

This topic explains how interest rate changes affect borrowers, lenders and bond investors, when interest rate risk is high, short-term and long-term rates and benchmark rates (and how interest on a loan is calculated), and the traditional ways of reducing the risk without derivatives: choosing between fixed and floating rates, smoothing, matching assets and liabilities and gap management, with worked examples. The next topic covers interest rate derivatives.

The syllabus asks candidates to explain the nature of interest rate risk and the methods of managing it. Read currency futures, options and swaps first.

The nature of interest rate risk

Interest rate risk is the potential for losses from a change in interest rates. It arises because a business does not know how much interest it will pay on borrowings already made or planned, or earn on deposits. Interest rates can move up or down, and the effect depends on the position:

• Floating-rate borrowing: the interest cost rises when rates rise and falls when they fall. A company with a ₦2bn loan at the benchmark rate plus 2.5% pays 25.5% when the benchmark is 23%, or ₦510m a year; if the benchmark rises by 2 percentage points the cost is 27.5% or ₦550m, an extra ₦40m a year. On ₦5bn, one percentage point is ₦50m.
• Fixed-rate borrowing (for example a bond): the interest cost is certain, but if market rates fall the company keeps paying the old rate while competitors who borrowed at floating rates, or who issue new bonds, gain an advantage.
• Fixed-rate bond investors: a rise in yields makes the price of existing bonds fall, and a fall raises it (see the topic on valuing bonds); an investor who must sell before maturity is exposed.
• Deposits: a company that places surplus cash on floating-rate deposits earns less when rates fall.

The risk is greater for banks and investment institutions, whose business is financial assets and liabilities, but also for any company with large debts: a rise of 0.25% on a $500 million floating loan costs $1.25 million a year.

When is the risk high?

Interest rate risk is high when changes are frequent and large and it is uncertain whether the next move is up or down. Volatility is higher when expected inflation is high; the high and changing interest rates in Nigeria therefore make the risk significant.

Short-term and long-term rates, benchmarks and how interest is calculated

• Short-term rates are money market rates, for borrowing and lending from overnight to about 12 months. They affect short-term loans and all variable-rate lending. Long-term rates are bond yields, and affect bond investors and issuers.
• A company’s bond yield depends on the risk-free rate (government bonds) and on credit risk. If a bond rated AA is downgraded to A+, its yield rises and its price falls; but that is credit risk, not interest rate risk.
• Benchmark rates. Floating loans pay a margin over a benchmark, for example the interbank offered rate: in Nigeria the Nigerian Inter-Bank Offered Rate and the Central Bank’s Monetary Policy Rate (23% since 22 September 2026) guide rates. The London interbank offered rate was the international benchmark but has been replaced for most purposes by risk-free benchmarks such as the secured overnight financing rate in dollars. Examination questions may still use it for illustration. The margin is stated in basis points (100 basis points = 1%): 250 basis points is 2.5%.
• Resetting. The rate for each interest period is fixed by the benchmark at the start of the period and reset for the next.
• Day count.
  Interest = principal × annual rate × days ÷ 365 for sterling, and ÷ 360 for the dollar.
  For $1m for 90 days at 6%, interest is $15,000 on the 360 basis and $14,795 on the 365 basis.
  In an examination use months ÷ 12 unless told otherwise.

Choosing between fixed and floating

Fixed borrowing gives certainty of cost but may be dearer if rates fall; floating borrowing is cheaper if rates fall but exposes the company if they rise. Which is better depends on the view of rates, the company’s ability to bear a rise in cost (interest cover), and the pricing: a fixed rate normally includes a premium for the lender taking the risk.

A company with stable, predictable cash flows can bear floating risk; one with thin interest cover should fix. A ₦4bn loan at a floating rate of 26.5% costs ₦1,060m, and ₦1,140m if the benchmark rises by 2 points (+₦80m). A fixed rate of 25% would cost ₦1,000m, ₦60m less than the floating rate today and certain.

Smoothing

Smoothing means keeping a balance between fixed-rate and floating-rate borrowing (or deposits), so that the effect of any move is partly offset. A company with ₦3bn of debt can fix half at 24% and leave half floating at 25%. The interest costs, and the average rate, under three conditions:

The all-floating debt swings by ₦90m either way; the mix swings by only ₦45m. Smoothing does not remove the risk and does not pick the best outcome; it halves the uncertainty and also halves the benefit of a fall. Staggering the maturities of fixed loans (so that they are not all refinanced at the same time) is a similar idea.

Matching assets and liabilities

Matching means holding assets and liabilities that earn and pay interest on the same basis, so a rate change affects both. A company has a deposit of ₦400m earning the benchmark plus 1%, and a loan of ₦450m costing the benchmark plus 2%.

With the benchmark at 22%, interest received is 23% × 400 = ₦92m and paid 24% × 450 = ₦108m, a net cost of ₦16m. If the benchmark rises 3 points to 25%, interest received is 26% × 400 = ₦104m and paid 27% × 450 = ₦121.5m, a net cost of ₦17.5m, only ₦1.5m more. Without the deposit, the loan alone would have cost ₦13.5m more. The closer the amounts, the better the match.

Matching can also be of maturities: financing long-term assets with long-term funds and short-term assets with short-term funds, so that a loan does not have to be refinanced at an unknown rate while the asset is still earning.

Gap management

For a bank or a company with large financial assets and liabilities, gap analysis compares the amounts of assets and liabilities that will be repriced in each period. A positive gap (rate-sensitive assets exceed rate-sensitive liabilities) gains from a rise in rates; a negative gap loses.

With rate-sensitive assets of ₦8bn and liabilities of ₦11bn the gap is −₦3bn; if rates rise 2 points, net interest falls by ₦3bn × 2% = ₦60m; if they fall 2 points, it rises by ₦60m. Management reduces the gap towards zero by changing the mix of fixed and floating items, or uses derivatives for the remainder (the next topic).

The ideas in more depth

Why the aim is stability and not a lower cost

Nobody can consistently forecast interest rates better than the market, so a policy based on a forecast is a gamble. A company’s business is to make and sell goods, not to speculate on rates. The purpose of management is to make sure that a bad movement in rates does not threaten the ability to pay interest, break covenants, or make planned investments unprofitable.

The reduction of uncertainty is the benefit, and some give-up of the chance of a lower cost is the price.

Why matching is the cheapest hedge

If a rate rise raises both the income on assets and the cost of liabilities by similar amounts, nothing needs to be bought. Natural offsets cost nothing, which is why they are tried before derivatives. They are limited by the actual mix of the company’s assets and liabilities, which is determined by its business, not by its wish to hedge.

Sources and references

• The Central Bank of Nigeria sets the Monetary Policy Rate; benchmark rates for interbank lending and for treasury bills are published by the Central Bank and the FMDQ market. International Financial Reporting Standard (IFRS) 7 requires disclosure of the sensitivity of profit to interest rate changes. The figures in the examples are illustrative.

These points are stated as at 5 November 2026.

Worked examples

1. Cost before.
   25.5% × 2bn = ₦510m.
2. Extra.
   27.5% × 2bn = ₦550m, so ₦40m more.

1. Gap.
   8 − 11 = −₦3bn.
2. Effect.
   −3bn × 2% = −₦60m of net interest.

1. Percentage.
   250 ÷ 100 = 2.5%.

How to answer in the exam

• State the exposure: which items are floating, which fixed, and the effect of a rise and of a fall.
• Quantify the change in interest cost for a stated change in rates.
• Apply matching and smoothing first and show the remaining exposure.
• Recommend a mix, explaining that the aim is to limit uncertainty.

Common mistakes in the exam

• Saying that a fixed-rate borrower has no interest rate risk.
• Confusing a rise in a bond’s yield caused by a downgrade with interest rate risk.
• Using annual interest for a part-year loan.
• Treating 100 basis points as 10%.
• Matching amounts but not the type of rate.
• Presenting hedging as a way of getting the lowest interest cost.

Quick revision

• Floating borrowers lose when rates rise; fixed borrowers lose when they fall; bond prices fall when yields rise.
• Risk is higher when rates are volatile; 100 basis points = 1%.
• Traditional hedges: fixed or floating, smoothing, matching, gap management.
• The aim is to limit uncertainty, not to find the lowest cost.

Practice questions

These are original questions written in the style of the Institute’s exams. Try each one before you open the answer. Section A is a recall check, because the paper itself is written.

Recall check: multiple choice

Section B style: written questions

A further written question

Model answers

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