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Interest rate hedging is one of several financial management techniques that can be used to protect an investor from sustaining some type of loss due to shifts in the prevailing interest rate. There are several different ways to utilize this approach, ranging from placing both upper and lower limits on the rate attached to debt instruments to setting up a forward or swap that can be invoked when and if certain conditions should occur. The specific selection of which approach to employ will depend on the predictions of what will happen in the market and how it will impact the particular type of investment involved.
One of the strategies that may be used in interest rate hedging is the establishment of a cap. The cap is basically the highest level that the interest rate applied to the instrument may rise. A cap is helpful with loans and other debt instruments, since it means that even if the average rate continues to increase, the debtor will only see the rate of interest applied to the debt increase to that point. This means that the rate of interest paid remains within a range that he or she considers acceptable.
The opposite of imposing a cap on interest rates is the floor rate. This particular approach to interest rate hedging focuses on making sure the rate applied to a given transaction will not fall below a certain amount, even if the average rate continues to plummet. This can be helpful with a number of investments in which the investor generates return based on the rate that applies. By making sure that the applied rate is never less than the floor rate, the investor is assured of generating at least a minimum return.
Interest rate hedging can involve the application of an interest rate collar, in which both a cap and a floor rate is set. This strategy helps to protect the interests of both the issuer and the investor in a given investment scheme. In addition, an approach known as an interest rate swap may be established, using a companion contract that makes it possible to exchange or swap a variable rate for a fixed rate for a specified period of time, if and when certain conditions prevail. Interest rate hedging can even be used with a forward, making it possible to lock in the good rates of today but not begin to pay on the transaction until several months later, essentially making the debtor immune to any increases in interest rates that may occur in the interim.