How can you structure a deal to reduce interest rate risk?

2 Floating-rate debt

Another way to reduce interest rate risk is to use floating-rate debt, which means that the interest rate and the principal payments are adjusted periodically based on a reference rate, such as LIBOR or prime rate. Floating-rate debt reduces the initial interest rate and allows you to benefit from falling interest rates. However, floating-rate debt also exposes you to the risk of rising interest rates and increases the variability and unpredictability of interest payments.

3 Interest rate swap

A third way to reduce interest rate risk is to use an interest rate swap, which is a derivative contract that allows you to exchange fixed-rate payments for floating-rate payments, or vice versa, with another party. An interest rate swap can help you hedge your interest rate exposure and match your debt structure with your cash flow profile. For example, if you have a fixed-rate debt but expect your cash flows to vary with the market interest rates, you can enter into a pay-floating swap to convert your fixed-rate payments into floating-rate payments.

4 Interest rate cap

A fourth way to reduce interest rate risk is to use an interest rate cap, which is a derivative contract that gives you the right to receive a payment from another party if the market interest rate exceeds a certain level, called the cap rate. An interest rate cap can help you limit your downside risk and protect you from rising interest rates. For example, if you have a floating-rate debt but want to avoid paying too much interest, you can buy an interest rate cap to receive a payment if the market interest rate goes above the cap rate.

5 Interest rate floor

A fifth way to reduce interest rate risk is to use an interest rate floor, which is a derivative contract that gives you the right to receive a payment from another party if the market interest rate falls below a certain level, called the floor rate. An interest rate floor can help you secure your minimum return and protect you from falling interest rates. For example, if you have a floating-rate asset but want to ensure a minimum income, you can buy an interest rate floor to receive a payment if the market interest rate goes below the floor rate.

6 Interest rate collar

A sixth way to reduce interest rate risk is to use an interest rate collar, which is a combination of an interest rate cap and an interest rate floor. An interest rate collar can help you narrow your interest rate range and reduce your interest rate volatility. For example, if you have a floating-rate debt but want to limit your interest rate exposure, you can buy an interest rate cap and sell an interest rate floor to create a collar that defines your maximum and minimum interest payments.

7 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?