Executive Summary
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Interest rate risk can manifest itself in several different ways.
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It is best managed within the context of the firm and a risk framework.
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Proper evaluation or measurement is key.
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Selection of a good key performance indicator is essential.
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A typical response to interest rate risk is a transfer of risk to another party.
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Many risk transfer tools are available, of which interest rate swaps are the most popular.
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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.
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