How Interest Rates Affect BHP Billiton - Assignment Example

A Report on Assessing the Hedging Strategy of BHP Billiton Name Institutional Affiliation Date Introduction BHP Billiton is one of the companies listed on Australia’ Securities Stock Exchange (BHP Billiton 2005). The company is affected by interest rates in several ways. Therefore, this report assesses the company’s hedging strategy given the existing exposure it has to the risk of interest rates. The report, address how interest rates affect BHP Billiton, the policies BHP Billiton used in managing interest rate risk and the new interest rate hedging recommendations applicable to the company. Question 1: How Interest Rate Risk Impacts on BHP Billiton Company The results of variance in interest rates from 1979-2009 are as shown in the Figure below. These are the results that BHP Billiton can rely in generalizing into the future economy and can utilize the information in controlling its investment portfolio as discussed herein. Interest rates are a major component in day to day activities of BHP Billiton. The company acquires loans from banks when they have insufficient funds and pays back the money with interest. When the company has extra cash, it is banked in savings accounts where they receive interest. Similarly, interest is also charged on customers who purchase goods or services by the various forms of credit purchasing for example, hire purchase. A change in the interest rates has a great effect on BHP Billiton’ customers’ purchases trend. High Interest Rates Rates of interest will have a direct relation to cash float in BHP Billiton’s economic system (BHP Billiton 2005). It determines the floats held by banks, car and house mortgage rates, interest rates charged on customers, the rate of giving out loans in banks and amounts loaned by credit cards. When the demand is high and the rate of cash flow is low, the cash tends will be more worth than under normal circumstances. In these cases, banks charge a high interest rate on loaned cash which reflects its scarcity. For BHP Billiton, this is the best time to make monetary investments like selling of shares that will gain them a lot of money compared to if they dispose them in times of low interest rate. Low Interest Rates Low interest rates means that money circulating in the system is excess. In such cases, the banks have a lot of cash which they are ready to lend out which forces them to lower their interest rates charged on loans to attract customers. Low interest rates also affect the price of goods as operation and production costs of companies are relatively lowered. For BHP Billiton, this is the time to make capital investments with anticipation of a good payoff when interest rates shoot up (BHP Billiton 2005). . Business Planning BHP Billiton can use the fluctuation of interest rates to their advantage. This is achieved by the company closely monitoring the trend of interest increase and decrease and planning expansion of operations and opening of new branches in the periods of low interest rates. In periods of low interest rates, operation costs go relatively low and the company also has a lot of cash in its possession. When companies expand or open new branches, there is more capital investment and hiring of more employees. Money paid to all the employees is termed as money released to the consumer sector, which they again use in purchasing of goods and services. Increased goods and service purchase lead to increased rate of production which in turn greatly increases the interests realized by the company. As consumers buy more goods, BHP Billiton will increase prices which lead to a further increase in profits and increased production to meet the constantly growing consumer demand. Increased business activity and price increases gradually lead to increase of interest rates and money starts getting scarce as the cash flow in the system is reduced. For BHP Billiton which is growing, careful studying of this cycle is of great assistance when it comes to expansion and diversification of its operations (BHP Billiton 2005). Question 2: Policies used by Company BHP Billiton to Manage Interest Rate Risk Changing interest rates is unpredictable and can subject BHP Billiton to a business to risk (BHP Billiton 2005). However these risks can be hedged to reduce their impact. A number of policies discussed below can be used to mitigate and manage the effect of interest rates risks. Swapping of interest rates This is an agreement between one financial and another financial institution to exchange interest rates between them for a certain time frame agreed upon. There are two events in a swap; one is known as a fixed leg, where the payer makes fixed payments. The other is called floating leg, where, depending on the floating interest rate index, a floating rate payer makes payment. There is no exchange of principal under this arrangement, no fee paid, and the price, paid by the owner is entirely the fixed rate. Agreements on the day the payments are to be made are conducive for individual business requirement. Its main objective is to hedge risks that are long-term. Caps Caps specify a maximum value in floating interest rates. They are ceilings that prevent interest rates from going beyond the specified cap rate. Caps are to some extent a form of insurance, making sure at a certain cap level the maximum borrowing rate is not exceeded. A premium is thus paid to financing institution by the purchaser. They are advantageous especially in short-term interest rates if the rates are low. Floors Floors, on the other hand, are a mirror image of caps. They offer protection against rates when they are falling in a floating loan rate. A possible rise in interest rate is beneficial also. In case the interest rate goes below BHP Billiton’s agreed floor, then the seller of that option will incur the difference in a case where the interest rate goes lower than the agreed upon floor. Thus investment is hedged against a drop in the interest rates. Collar A collar comes about when BHP Billiton longs a cap and shorts a floor. It minimizes the rate risk at a low cost. The cap premium due is offset by the one received for the floor. Here the additional cost on the cap is reduced and the rate that is maximum is still capped. It is essential in BHP Billiton’ management of floating rate liabilities. It provides a ceiling that shields on a variable rate index and also a floor if sunk deeper no more benefits out of the rates that are declining. Forward Rate Agreement This is an agreement between lender and the client, where the borrower is at liberty to borrow at a fixed later date in the future but the terms of agreement are of the present day. This means that the borrower can get a loan in future at a fixed rate that is agreed upon presently. The borrower and lenders are protected against fluctuation of interest rates in the future. A fee is paid to secure this day in the future. The fee paid is dependent on certain factors such as, the loaned amount, settlement time, term of the fixed rate and the frequency of repayment. Question 3: New Interest Rate Hedging Recommendation for BHP Billiton Company Changes in interest rate decision will affect BHP Billiton in a number of ways depending on the amount that the company has borrowed and the terms surrounding the borrowing, the company’s balances, and the fact that the company thrives in a market condition that is dependent on how a consumer spends (BHP Billiton 2005). In situations of high interest rates, some consumers may choose the option not to spend or to reduce spending and may be less willing to incur credit purchases as a result affecting the BHP Billiton’s income. In fact, impacts associated with interest rate hicks can disproportionately impact on the demand for the goods that are bought on credit and the luxury commodities. This will greatly affect BHP Billiton and one of the principle strategies should be creating new market and giving some incentives to its customers to motive them. It can also improve its technology so as to produce at lower costs, and consequently lower the high prices that would otherwise discourage its customers. As far as BHP Billiton is concerned, there are a number of policies it can use in management of the risk associated with interest rate. First, BHP Billiton should start analyzing overall conditions of the market, loan portfolios and the earnings with regard to foreign currency and formulate one of the most profitable strategies to lower agreed interest rate. The strategy for reducing interest rate will be based on optional combinations and BHP Billiton should select, coordinate and implement one of the advantageous options or combinations. However, under the circumstance that prerequisites or market conditions change in the market, BHP Billiton must revise its hedging strategy so as to offer the company with one of the most appropriate protection against risks associated with market conditions. Further, BHP Billiton should reduce its investment plans while the interest rates are high, lower the debt burdens, prepare and implement destocking, reduce redundancies, cut down the costs in order to maintain conserve cash and margins and offer price discounts so as to stimulate its demand (BHP Billiton 2005). For example, it is expected that recent remarks on economy will reassure businesses that the interest rates will remain low in the short term. The poll results released by Bank of England suggest the interest rates are expected to stay lower for longer periods as illustrated by the Figure bellow. Such a move means that BHP Billiton can keep its business strategies intense in the short term and avoid the risk of longer loans or debts that would fall into the future bracket whose interest rates are unpredictable. Conclusion Thus, the hedging strategy is the best mechanism through which BHP Billiton can protect its investment portfolio against unpredictable market conditions. It can be done both under the effect of high interest rates or low interest rates. References Top of Form BHP Billiton. BHP Billiton sustainability report: Summary report. Melbourne, Vic: BHP Billiton; 2005. Bottom of Form Read More