Absolute interest rate risk occurs when we are exposed to directional changes in rates – either up or down. This is the main area of rate risk that gets monitored and analysed within a company as it is immediately visible and has a potential effect on profit.
Let us look at an example:
A chemical company builds a business case for a new product and decides to start a new factory to manufacture the product. It is expected that the product will be sold over 10 years. The factory costs €1 billion, and the company decides to borrow €500 million from the bank at an interest rate of 3%, which it will pay back over 5 years. The price of this product is then set based upon this interest rate. What if interest rates go up during these 5 years, and the company wishes to extend the loan? The bank may only agree to extend at an interest rate of 8%, for example. This is a major risk. To mitigate it, the bank may offer a financial instrument which hedges this interest rate risk. Alternatively, the company may decide to put more of its own money into the project, or it may seek out other parties who are willing to fund the project for 10 years at an acceptable rate.