Businesses often require funds for a longer term than the usual 90-day term of a bill and so will be provided with a bill facility. This is an agreement to rollover bills on their maturity date by issuing a replacement set of bills, however there is potential that borrowers will be exposed to interest rate risk. Interest rate risk is basically the threat posed by un expected changes in interest rates, in other words, it can be defined as the uncertainty surrounding expected returns on security, brought about by changes in interest rates. Given that a borrower uses 90-day bills under a two-year bill facility, the bills will be rolled over seven times so that the loan is repaid at the end of two years. This arrangement is a floating-rate arrangement that exposes the borrower to the risk of an unexpected rise in interest rates that will increase its cost of funds while not increasing its interest earned on the loan. The borrower faces interest rate risk throughout the period of the facility because the amount raised is determined by the spot rate each time the bills are issued. Should rates rise unexpectedly, the borrower would have to pay the higher-than-expected interest rate. For instance, should the spot 90-day rate be higher than the forward rate of the month, the borrower will have to pay more for its funds.

The main method for managing interest rate risk is to use a derivative which is an instrument that features a forward settlement (or maturity) date. It provides the hedger with a forward rate that is based on the expected future interest rate. For the borrower it removes the risk of having to pay a higher interest rate (than the forward rate). But the forward rate removes the upside potential, thus, if the future spot interest rate is lower than the forward rate on the day the funds are borrower, the borrower pays the forward rate. This means the borrower now faces the risk of lower interest rates. Thus, the hedge (the forward rate) does not eliminate risk absolutely, it changes the risk exposure. The instruments that serve to hedge an exposure to future spot interest rates include FRAs, BAB futures and interest rate swaps. A hedge instrument that establishes a forward rate is simultaneously establishing a hedged amount. This amount is calculated with the forward rate. In most of these derivatives the contract is settled with a cash settlement calculated as the difference in the hedged amount and the actual proceeds from the issue of money market securities. Where the future spot rate on the settlement date for the hedge contracts is higher than the forward rate, the derivative contract is settled with a payment to the company that equals the difference in the hedged amount and the actual proceeds from the issue of securities. The purpose of the cash settlement is to compensate the borrower for paying a higher interest rate (than the forward rate) and so adds to the proceeds, bringing them up to the amount that corresponds to the forward rate. The hedge contract is referred to as ‘locking in’ the forward rate because the borrowing is made at the spot rate in the money market and the cash settlement adjusts the proceeds to match the amount given by the forward rate

A forward rate agreement (FRA) is an OTC contract with a bank that serves to establish a forward interest rate for the specified future date on a nominal amount for a set period to manage risk. FRAs are identified by their starting date and finishing date. They are arranged with dealers, who earn their income from the spread between the forward rates they provide