| A new dawn in interest rate risk management |
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| With rising debt levels for many Irish companies interest rate movements have become more important to business performance. Jayne Bull and Brian Lynch look at how Irish corporates are addressing the challenges of proactive interest rate management. |
As debt levels have increased and interest rate movements have become more important to the bottom line, Irish corporates have risen to the challenge of the need for a proactive approach to interest rate risk management. Allied to this is the increasing range of products available to companies to manage their risk in a more tailored manner like caps, swaptions and swaps. Rather than concentrating on specific products, this article focuses on the risk management process and the trends in risk management that we have seen over the past few years, particularly since the introduction of the Euro.
Risk Management
Risk Management is the process of identifying risks, quantifying them, determining for how long they will arise, deciding whether or not to hedge them and how a hedge may best be implemented.
Although most people have a negative perception of risk, it is in fact just variability of outcome, which can in fact be positive or negative. For example, fixing the interest rate does not eliminate interest rate risk, it changes the profile from one where interest rate rises are negative to the profit and loss account (floating debt) to one where they are positive/neutral. The flip side of course is that it opens up risk to interest rate decreases.
But risk management does not mean never losing money, through either opportunity or real cost. It means measuring the risk and balancing it against the company’s appetite for that risk. Risk management is an attempt to achieve an appropriate solution that achieves the company’s objectives on its financial risks without impacting its business risks.
A typical Risk Management Policy is a 4-step process: See diagram
Objectives
A Corporate’s Treasury function typically has three broad objectives with regard to interest rate risk management. Firstly the aim is to raise funds as cheaply as possible. Secondly to invest excess funds for as high a return as possible and lastly to manage the interest rate risks in the company.
These are not mutually exclusive objectives. For instance, yield curves are typically (though not always) upward sloping. That is 3-month money is cheaper than 5-year money. So you could achieve the first objective by borrowing at the 3-month rate but this will open up exposure under the last objective.
In general when framing an interest rate risk management objective, the decision is basically how much of your interest rate risk you intend to keep variable and how much you wish to keep controlled (i.e. fixed or capped/collared)?
Implement
Once you have a policy, you then need to put it into practice. This means deciding to hedge or not, what period, what amount and how.
Monitor
Without getting into a discussion of dynamic versus static hedging, it is important to bear in mind that interest rates are changing from one minute to the next, as is your cash flow. As a result of these changes, it is important that existing hedges are continuously reviewed to monitor their effectiveness. We are seeing increasing evidence of this process. Companies that have fixed rate debt are unwinding or extending the hedges as their cash flow profile and interest rate views change.
Trends in debt hedging
In general we have seen a much more proactive approach by corporate treasuries in their interest rate risk management. This is a function of a number of factors, but primarily we have seen the following: -
Increased gearing levels among Corporates due to debt being an important and relatively cheap source of capital. As gearing rises, so does the importance of interest rate movements on the bottom line.
Increased activity by Irish corporates in mergers, acquisitions and expansion. This has increased debt levels and frequently the number of currencies to which a corporate is exposed.
Increased sophistication in treasury functions. As interest rate risk management has become a more important function, training and education in these areas has expanded.
The Euro has opened up a much more liquid market which in turn has led to a more extensive product suite that is available to hedge domestic debt, and is currently being used by Irish corporates.
Clients with existing hedges
When hedges are due to mature in the near future, rather than waiting for the hedge to expire we are seeing a much greater interest in hedging the position in advance. Capping and fixing debt are the most popular methods, but we are also seeing increased use of more flexible swaps such as Extendable and Cancelable Swaps.
When hedges are not due to mature for some time the existing hedge may be at a higher rate than currently available. By using the ‘break and blend’ approach, corporates are finding it easy to accurately alter and re-match their interest rate hedging to their actual requirements, subject to credit approval, without the expense of having to pay costly break charges.
When the existing hedge is at a lower rate than currently available, the ‘break and blend’ approach is again being used and valuable hedges are being used to lower future interest rate costs. At a time when cash flow is strong and higher interest rate costs can be tolerated in the short term, corporates are prepared to spread the imbedded benefit over a longer tenure to protect against rising interest rates in the future where the outlook is uncertain
Clients without existing hedges
Caps, collars and swaptions are being used by corporates who are interested in strategies that give protection from a sharp moves upwards in interest rates while also giving the ability to benefit from moves lower. These corporates are not necessarily interested in fixing at current levels but are mindful to ensure that their exposure to further rate rises is limited.
Although this article has focussed on interest rate management, tax and accounting implications are equally important and should always be considered. As we have discussed it is very important to identify exposures to interest rate movements and proactively manage them to reduce their impact on your underlying business. If your interest rate risk is not hedged it should be a decision taken within the framework of your overall hedging policy. If you are focussed and proactive in identifying exposures early and deciding on the appropriate action, it will negate the necessity of having to be reactive on foot of adverse rate movements.
Note: Any opinions expressed constitute Ulster Bank’s judgement as of the date published, are subject to change without notice and are not intended to and may not be construed as constituting investment advice. The products mentioned can be complex in nature and we recommend that you obtain independent legal and tax advice where appropriate. |
Brian Lynch and Jayne Bull, both of Ulster Bank Group Treasury, collaborated on this article. Lynch is head of derivative sales and Bull is head of structured treasury products.
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| Article appeared in the October 2000 issue.
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