Glenn D. Pederson

Credit Policy Risk and Interest Rate Risk in Agricultural Finance: Discussion

The two papers on interest rate risks provide useful discussions on the effects of interest rate fluctuations in agriculture and strategies to mitigate those effects. Both discussions emphasize that several factors have contributed to interest rate variability and increased sensitivity of the farm sector to rate changes. Agricultural borrowers and lenders must incorporate interest rate variability into their operating and strategic financing decisions. The issue of interest rate risk management is sufficiently new that several of the cited effects form hypotheses for applied research. Missing from both papers was a clear definition of interest rate risk. Interest rate risk derives from interest rate fluctuations but not in the same way that price risk derives from commodity price fluctuations. The fundamental difference lies in how inflation is transmitted. For example, if the annual inflation rate increases by 6% (and inflation is correctly anticipated) a 6% inflation premium is added to an existing market interest rate of 10% resulting in a 60% increase in the cost of borrowing. Thus, fluctuations in inflation translate into proportionately larger changes in interest rates than in other prices. The other significant difference is that price increases reflect actual inflation while interest rate increases reflect anticipated inflation. Thus, interest rates may remain temporarily high while prices decline. Interest rate risks are basically different for farm borrowers than for lenders but can be measured in similar ways. Because variations in interest costs inversely affect farm earnings after interest payments, farm profit margins are altered. Analogously, interest rate movements create differential rate flows on lender assets and liabilities with varying degrees of rate sensitivity. Therefore, net interest margins are altered. In each case, interest rate risk is the variability of profit margins attributable to interest rate movements. The lenders interest rate risk is lost interest income due to