Use customised loan terms to lower the cost of capital

An employee makes notes in front of an electronic stock information screen inside the Nairobi Securities Exchange Ltd. (NSE), in Nairobi, Kenya, on Tuesday, Dec. 8, 2015. [File, Standard]

Financial markets are critical to any economy because they channel funds from those who do not have a productive use for them to those who do.

The result is economic efficiency.

Our financial market lags behind in terms of products and services since there are only a few securities traded at the Nairobi Securities Exchange (NSE).

The only visible securities at NSE are shares or stocks.

As such, the Nairobi bourse must redouble its efforts to attract more securities in the market. Options and futures were to be traded but are not visible.

Active trading of securities used by corporations signifies liquidity or the ease with which they can be converted into cash and ultimately low-cost capital to businesses.

The cost of financing is critical to businesses because those unable to access it due to the high cost would cut their investment.

Low investment means capital injection into plant and equipment will fall, and citizen will be denied access to both related goods and services as well as jobs.

The cost of money is that when you borrow cash, you pay interest.

Lower income 

Thus, a change in the interest rate affects the cost of acquiring funds for financial institutions and changes the income on assets such as loans. This ultimately affects the profitability of financial institutions and other business.

Any business that borrows expensively will experience lower income and less profit to investors as changes in interest rates affect the value of assets.

An increase in interest rate lowers the value of assets, while a decrease increases the value because the cash required to invest in the asset becomes cheap.

For example, if interest rates rise substantially, assets will suffer a sharp decline in their prices.

It is thus a fact that the Central Bank of Kenya manages interest rate in a manner that balances the demand and supply for funds to achieve stability in the economy.

There are many tools that can be used by businesses and other organisations to manage interest rates while reducing risk and the cost of capital.

Interest risk management is a major concern for bank managers.

No market player can be certain about future levels of interest rates. However, the financial markets discriminate borrowers on the basis of the loan seeker’s risk characteristics.

The result is the lack of convergence between the interest of the lender and borrower.

Borrowers and lenders might agree on the floating interest rate or fixed interest rate.

If the financial institution offers you a loan at a fixed interest rate, then the interest you pay on the amount borrowed will not change.

For example, if the interest rate is 10 per cent, then it will not change during the entire term of the loan. In other words, it remains the same throughout a set period. 

However, if you default on any instalment, the cost of the loan will go up. The borrowers who do not want their interest rate expenses to change will opt for a fixed interest rate.

Interest rate

The advantage of a fixed interest rate to corporations is that it makes it easier to budget.

The question then is, who is likely to ask for a fixed interest rate from lenders? The most likely candidates are those who expect interest rates to go up.

Conversely, the lender would prefer a floating rate in the hope that interest rates would rise.

A fixed interest rate ensures that a borrower is cushioned against adverse exposure to increases in the interest rate.

If the borrower desperately needs money, then the lender’s terms prevail. The loan seeker might, therefore, be forced to borrow on terms that favour the lender and not the borrower.

The borrower can come out of this situation by swaps instrument. Floating interest rate - also known as adjustable rate changes periodically.

A floating interest rate moves up and down with the market and is more realistic to the majority of the market players.

Businesses that expect an interest rate to decline soon will prefer a floating rate even when the lender insists on a fixed rate.

Again, the lender might force a fixed rate on the borrower even if they prefer a floating rate.

How does the lender come out of such an adverse situation?

Swap is useful in reconciling borrowers who prefer fixed interest rates, yet one is required to borrow at a floating rate.

In a swap, the two firms with adverse interest rates agree to exchange cash flows in the future, with a financial institution acting as an intermediary.

The pact is specific on the dates on which the cash flows are to be paid and the way they are to be calculated.

The good thing with swaps is that both firms will benefit from a decline in the cost of money and that the connecting financial institutions will generate income for themselves

-The writer teaches at the University of Nairobi.