Interest rate risk management – the calm before the storm?

Interest rate risk management

Source: KPMG Corporate Treasury News, Edition 44, June 2015


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There have been highly interesting developments in the money and bond markets in recent weeks: First, the uncertainty about the impact of purchase programs of the European Central Bank. Then, the predictions of commercial banks about future liquidity shortages in the bond markets, which could overshadow the primary and secondary markets. Ultimately, ten-year rates will rise based on inflationary expectations, even though at the beginning of the year it was still expected with certainty that the long end of the yield curve will drop further.

How is this going to impact companies and treasury departments? A rise in interest rates will have a significant effect on a company's overall profitability, regardless of the actual level of increase. The required amount of refinancing is usually easy to identify - however, the impact of a rise in interest rates and associated reduction in future interest income is far less transparent. Moreover, financial instruments to control interest rate risk exposures are often focused on the past, i.e. on completed financing, rather than planned future financing and for example the effect of future interest income on financial ratios (such as ratings and financial covenants).

So why is it necessary to put this issue on the agenda? Because it is tremendously important to have a clearly defined interest risk management strategy and a fixed set of measures to hand when entering a market scenario of rising interest rates. Nothing is more fatal for a treasurer than being wrong-footed and having to catch up with market developments. The main requirements for robust interest rate risk management therefore are as follows: 

  1. A strategic management approach needs to be clearly defined and formulated. In some cases it can be useful to use a micro-management approach, e.g. for financing transactions and the related financial derivatives. For complex value chains, a cross-functional management approach such as asset/liability management should be considered, i.e. the cross-functional management of interest rate risk exposures, both under assets and liabilities.
  2. Analysis of the risk associated with interest rate risk exposures can be easily tackled with a fair value analysis. Initial statements can be made by evaluating existing financing based on the current market environment. Likewise, an analysis of the individual grid points of the yield curve allows identifying changes in the market environment early on, so that budgets can be adjusted accordingly depending on the level of impact.  
  3. In addition, scenario analysis of the interest rate sensitivity of risk exposures and the evaluation of possible alternative actions provide the opportunity of examining established exposures for possible changes with relatively simple means.

In following this approach, the treasurer is now in a position to derive a clear course of action for a scenario of rising interest rates and to discuss and coordinate it with management. The tools are now in place. But, who knows, maybe the storm will subside and the treasurer will continue to have to battle with the no less complex impact of negative interest rates...

Author: Stephan Plein, Senior Manager,

Corporate Treasury

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