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Home > Financial Risk Management Best Practice > Managing Interest Rate Risk

Financial Risk Management Best Practice

Managing Interest Rate Risk

by Will Spinney

Executive Summary

  • Interest rate risk can manifest itself in several different ways.

  • It is best managed within the context of the firm and a risk framework.

  • Proper evaluation or measurement is key.

  • Selection of a good key performance indicator is essential.

  • A typical response to interest rate risk is a transfer of risk to another party.

  • Many risk transfer tools are available, of which interest rate swaps are the most popular.

  • The risk is usually transformed rather than eliminated.

Introduction

Almost all firms are exposed to interest rate risk, but it can manifest itself in different ways. A proper response to this risk can only come following a full understanding of the context of the firm and its strategy, along with a full evaluation of the risk. Firms should generate a well thought out key performance indicator (KPI) and then apply one or more of the many tools available in the market to transfer interest rate risk.

Major Ways That a Firm Can Be Affected

Interest rate risk is the exposure of the firm to changing interest rates. It has four main dimensions:

Changing Cost of Interest Expense or Income

Companies with debt charged at variable rates (for example, based on Libor, and also called floating rates) will be exposed to increases in interest rates, whereas companies whose borrowing costs are totally or partly fixed will be exposed to falls in interest rates. The reverse is obviously true for companies with cash term deposits. This is usually the key risk that firms consider.

Impact on Business Performance by a Changing Business Environment

Changes in interest rates also affect businesses indirectly, through their effect on the overall business environment. In normal times, for example, construction firms enjoy a rise in business activity when interest rates fall, as investors build more when the cost of projects is lower. Conversely, some firms may benefit from high levels of activity that prompt a high interest rate response by central banks. So some firms may have a form of natural hedge against the other forms of interest rate risk, although for any one firm the effect may lead or lag actual changes in rates.

Impact on Pension Schemes Sponsored by the Firm

Pension schemes that carry liability and investment risk for the sponsor have interest rate risk in that liabilities act in a similar way to bonds, rising in value as interest rates fall and vice versa.

Changing Market Values of Any Debt Outstanding

Although a nonfinancial firm will usually report its bonds on issue in financial statements, at substantially their face value, early redemptions must be done at the market value. This may be significantly different, as interest rates will change the value of fixed-rate debt. This risk is not commonly considered by most nonfinancial firms.

Interest Rate Risk in the Context of the Firm

Investors do expect firms to take risks, especially with regard to their core business competencies. It may be that investors expect the firm to take interest rate risk. On the other hand, investors would probably not expect a firm to breach a financial covenant because of rising interest rates.

Risk Management Framework

A risk management framework includes the following key stages:

  • Identification and assessment of risks;

  • Detailed evaluation of the highest risks;

  • Creation of a response to each risk;

  • Reporting and feedback on risks.

Evaluation is crucial to the management of interest rate risk and will discover exactly how a firm might be affected, thus guiding the response to the risk. Evaluation techniques include: sensitivity analysis, modeling changes in a variable against its effect; and value at risk (VaR) analysis, based on volatilities to calculate the chances of certain outcomes.

Let us look at a simple firm with earnings before interest and tax (EBIT) of 100, borrowings of 400 (all on a floating rate), an interest rate of 6% (as a base case), and a tax rate of 30%, and apply some of these techniques.

Evaluation 1: Sensitivity Analysis

A 1% move in interest rates has an effect of 4 (1% of 400) on the annual interest charge. This is not very helpful because there is no context for the effect.

Evaluation 2: Sensitivity Analysis

A table can be constructed to show the effect on earnings and interest cover (Table 1). In the table items in bold represent the base case, whereas other columns represent the sensitivities to this base case. Earnings are earnings after interest and tax.

Table 1. The effect of interest rate changes on earnings and interest cover

Interest rate
4.5% 5.0% 5.5% 6.0% 6.5% 7.0% 7.5%
EBIT Interest Tax Earnings Interest cover 100.0 (18.0) (24.6) 57.4 5.56 100.0 (20.0) (24.0) 56.0 5.00 100.0 (22.0) (23.4) 54.6 4.55 100.0 (24.0) (22.8) 53.2 4.17 100.0 (26.0) (22.2) 51.8 3.85 100.0 (28.0) (21.6) 50.4 3.57 100.0 (30.0) (21.0) 49.0 3.33

This is much more helpful, showing the effect on both earnings and interest cover. If the firm has an interest cover covenant of, say, 3.75, then the table shows a high risk of a breach, depending on how likely a rise in rates might be.

Evaluation 3: Sensitivity Analysis

Suppose now that EBIT displays volatility. We can construct a further table (Table 2) showing interest cover under variations in EBIT and the interest rate. Italic numerals indicate a covenant breach, and the number in bold is the base case described in Table 1.

Table 2. Interest cover under variations in EBIT and interest rate

Interest rate
4.5% 5.0% 5.5% 6.0% 6.5% 7.0% 7.5%
EBIT
80 85 90 95 100 105 110 115 120 4.44 4.72 5.00 5.28 5.56 5.83 6.11 6.39 6.67 4.00 4.25 4.50 4.75 5.00 5.25 5.50 5.75 6.00 3.64 3.86 4.09 4.32 4.55 4.77 5.00 5.23 5.45 3.33 3.54 3.75 3.96 4.17 4.38 4.58 4.79 5.00 3.08 3.27 3.46 3.65 3.85 4.04 4.23 4.42 4.62 2.86 3.04 3.21 3.39 3.57 3.75 3.93 4.11 4.29 2.67 2.83 3.00 3.17 3.33 3.50 3.67 3.83 4.00

A drop of 5 in EBIT and a rise of 0.5% in interest rates will cause a breach, a clear risk factor for the firm. If a relationship between EBIT and interest rates can be established, then further conclusions could be drawn.

Sensitivity analysis does not show the probability of these changes, but if they are available—for example from a study of market volatility—a probability distribution for a covenant breach can easily be obtained.

Evaluation 4: VaR

Suppose that investigation of the assets and liabilities in the firm’s pension scheme shows that the scheme has a deficit of 50. As an illustration, VaR might tell us that, based on the volatility of the long-term interest rates used to calculate liabilities, and taking into account that the scheme has some bond investments (in which value moves are opposite to liabilities), there is a 1 in 20 chance that the deficit will increase in the next year, because of interest rate changes alone, by 15 or more.

Interest rate risk inside a pension scheme (or other scheme for future employee benefits) often dwarfs interest rate risk inside the firm.

Evaluation should reveal where a firm is sensitive to interest rates. It could be:

  • Earnings, perhaps where earnings per share (EPS) is an important issue.

  • Cash flow.

  • Interest cover ratios, perhaps because of financial covenants.

  • Other ratios, such as those used by credit rating agencies.

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Further reading

Books:

  • Buckley, Adrian. Multinational Finance. 5th ed. Harlow, UK: Pearson Education, 2004.
  • Chapman, Robert J. Simple Tools and Techniques for Enterprise Risk Management. Chichester, UK: Wiley, 2006.

Websites:

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