Corporates companies and investors are exposed to the risk that a change in interest rates will affect the value of their floating-rate investments of funding programmes.
We’ve prepared a comprehensive summary of all you need to know about interest rate risk to help you manage your exposure.
What is interest rate risk?
Interest rate risk is the potential impact on companies or investors or investments from a change in interest rates levels.
Interest rate risk for corporate companies: fast facts
For a company, interest rate risk represents the potential for a lower return on investments if rates fail or higher debt servicing costs if rates rise. Remember, rate risk is not the same as credit risk!
Interest rate risk is reflected in the income statement as:
- Lower financial income if interest fall,
- Higher debt servicing costs if interest rates rise.
Runaway hikes in interest rates might not be sustainable for a highly-leveraged company and could threaten its bottom line. The interest coverage ratio measures a company's ability to cope with a growing interest burden.
Interest rate risk appears on the balance sheet as a change in the value of a company's assets or liabilities and has a knock-on effect on key financial indicators, such as net debt-to-equity ratio (gearing).
Finance departments generally use a specialist treasury management solution (TMS) to map their exposure to this type of risk.
Interest rate risk for investors: fast facts
For investors in the financial markets, interest rate risk is the risk that changes in interest rates will reduce the value of an investment.
Take the bond market for example: a bond is a fixed-income investment and bond prices and yields move in opposite directions. If interest rates rise, bond prices fall and vice versa.
The sensitivity of a bond portfolio to changes in interest rates is measured by its duration. There are two types of metric:
- MacAulay duration: the number of years an investor must hold the pond position until the present value of the bond's coupons equals the amount paid for the bond (a metric not to be confused with maturity),
- Modified duration: measures the change in the value of a security in response to a 1% '1BP) change in interest rates.
Interest rate risk for banks: fast facts
By the nature of their business, banks are particularly vulnerable to interest rate risk - as both companies and investors - and must therefore be very vigilant.
Interests rates are at record lows, with some even in negative territory, which means banks are also seeing their commercial margins contract as central banks keep rate at rock bottom.
In this environment, banks, investment funds and insurance providers face a new "commercial interest rate risk" specific to their activity and have to adjust their business models or pricing structure to manage it.
Where does interest rate risk arise for a corporate company?
Interest rate risk for a company generally originates in the interest rate gap, in other words the mismatch between uses and sources of funding at variable rates.
In the world of finance, there are several different types of interest rate risk:
- Yield curve risk: following a move by a central bank or a change in consensus opinion in the interest rates market (steepening or flattening of the curve),
- Basis risk: when the difference widens between the price of an underlying and one of its derivatives in the futures market,
- Repricing risk: when renewing the terms of an investment (UCITS, Treasury bill, government bond, etc.) or a source of funding (borrowing from a financial institution, bond market issue),
- Optionality (covenants) risk: in the case of poor management of options associated with debts or receivables.
Simulating different scenarios is one way corporate treasurers can prepare for all eventualities and assess how resilient they would be to stresses, such as a hike in interest rates.
Scenarios and simulations can test a range of different assumptions about the future evolution of interest rates, including Stress testing unilateral yield curve translation, steps or percentage, as well the kind of choices a company can make, for example by comparing different sources of funding or growth models.
If an exposure is denominated in a foreign currency, exposure to foreign exchange risk can also be monitored to manage all the company's financial risk in a single tool.
How to hedge against interest rate risk?
Corporate companies can set up hedges using financial derivatives to mitigate their exposures to interest rate risk.
An interest rate swap (IRS) is a hedging instrument used to swap between floating and fixed rates, or to swap between one variable index to another. There are also options named as Swaptions.
This type of hedging strategy helps companies to determine the allocation between fixed and floating rates on investments and loans. What is the advantage? Judicious use of hedges reduces exposure to interest rate risk when the risk exceeds what is considered acceptable in the company's risk management policy.
But, there is no obligation on companies to have a hedging strategy in place. Hedging is a cost for a company and it is up to the finance and treasury departments to balance the costs and risks when making hedging decisions.
A professional approach and the right tools are essential to manage interest rate risk effectively and turn risk management strategy into a winning competitive advantage.