Subjecting themselves to interest rates risk will be any banking institution concern when making loans to customers. This is particularly true when the interest on loans is not fixed, but floats or adjusts according to the market or an index of some kind. Necessary to appraise the value of a loan, banks often find this a difficult job when the interest rates vary. When a bank carries a rather significant portfolio of loans whose value is not fixed, the problem is therefore compounded either negatively or positively. To be able to minimize the risk and prevent a major change in the value of the loans it makes, a banking identity may choose to make an interest rate hedge to ensure the bank's loan portfolio remains secure and profitable.
Entering into specific contracts with its borrowers allows the bank to create an interest hedge which protects them from loss. One form of contract is referred to as an interest rate cap. Not only requiring a fee from the borrower, this will cap or set a ceiling on the amount of interest that a borrower pays. For instance, the borrower can be protected against a rise in interest rate should a floating interest rate on the loan states that it cannot exceed above 8 percent, meaning the borrower has a specific cap, ensuring they will always be able to afford their loan as it matures.
Borrowers who are able to put a lower limit on the interest of their loan might actually get money back for being willing to enter a contract for an interest rate floor. This is another way that a bank can hedge its interest rate financial risk. Even if the market dictates that the interest on a loan should drop to 3.5 percent, if the borrower has consented to an interest rate floor of 5 percent, the borrower will pay the rate that is higher.
In some instances a borrower might choose what is called an interest rate collar. This is simply a combination of an interest rate cap and an interest rate floor. It puts both a lower and upper limit on rates of interest for the bank loan. These kinds of agreements are often without a cost because the fee a borrower might pay for the cap might be equal to the benefit it might receive for the floor.
Another way a bank can hedge the risk of interest rate modifications on a loan is to allow a borrower to enter into an interest rate swap. A swap permits a borrower to transform the floating interest rate on its loan to a fixed rate or one that doesn't change with the market. Any costs associated with the swap can be included in the rate change.
Banks can furthermore enter into contracts with their borrowers in what is known as forwards. By agreeing to something that can occur in the future is basically what a forward agreement is. Balloon payments is one instance of a forward, in which the loan could have a large amount due at the end of the loan. The borrower is thinking about renewing the loan at the end of the four month period but wants to lock in a fixed interest rate now. The locked in interest rate won't go in effect until a future date, thus, making this called a forward.
These are just a few examples how a lending institution protect themselves when entering into any type of loan as the interest rate hedge will ensure the value of their portfolio is certain to always be in their favor.