INTEREST RATE RISK: 3 EXAMPLES TO LEARN FROM
VERY THEORETICAL AT FIRST SIGHT, INTEREST RATE RISK POSES A VERY REAL THREAT TO CORPORATE COMPANIES, INVESTORS AND BANKS IF NOT MANAGED APPROPRIATELY. WHAT ARE THE RISKS? WHAT SOLUTIONS ARE AVAILABLE FOR MANAGING IT? THESE THREE EXAMPLES PROVIDE SOME ANSWERS.
Case 1: interest rate risk exposure for a corporate company.
Description:
Let’s imagine a company that has some of its funding programme at floating rates and an investment portfolio whose yield depends on fluctuations in interest rates.
The difference between uses and sources of funds at floating rates is known as the company’s “rate gap”. The wider the gap, the more exposed our company is to interest rate risk and the bigger the impact of rate volatility.
What are the risks?
There are two potentially negative situations for a company with a rate gap:
If the amount invested at floating rates is higher than its floating-rate sources of funds: it will be negatively affected if rates go down (the losses on its floating-rate uses of funds will be greater than the savings it makes on floating-rate sources of funds).
Conversely, if the amount invested at floating rates is lower than its floating-rate sources of funds: it will be negatively affected if rates go up (the gains on its floating-rate uses of funds will be lower than the losses it makes on floating-rate sources of funds).
N.B.: the risks are high for highly-leveraged companies. An increase in debt servicing costs as a result of rising interest rates could trigger large losses (if not adequately hedged) and could cripple a company – even to the point of bankruptcy. For heavily indebted businesses, interest rate risk becomes liquidity risk and/or credit risk.
What solutions are available?
To reduce exposure to interest rate risk, a company can set up hedging strategy to offset the interest rate gap. For example, it could use derivatives like interest rate swaps to exchange part of its floating-rate debt for a fixed rate.
But hedging interest rate risk comes at a cost. The company's finance department and treasury may well opt for a strategy of not hedging or only partially hedging a position, according to projections of the interest rates evolution.
Case 2: interest rate risk exposure for an investor.
Description:
Fluctuating interest rates can have a major impact on the value of a broad range of financial assets, especially fixed-income securities like bonds. Investors in these types of assets track interest rates very closely to adjust their positions as rates move up or down.
Let's take an investor in a bond that has a nominal value of €1,000 and pays a coupon of 4% over 10 years. The bond exposes our investor to interest rate risk.
What are the risks?
If rates are rising, the price of our investor's bond fails. It suddenly becomes less attractive than new issuances of the same grade and for the same duration on the market.
If the investor wants to sell the bond, it would mean incurring a loss as it would be sold at a price almost with the same yield as the new issues. Sometimes for less than par value - unless they initially purchased under the par.
Naturally, our investor might decide to hold the bond to maturity to avoid making a loss. But this raises the issue of opportunity cost, which is significant in this case: the €1,000 invested in the bond will have a lower yield than the one from another proposed investment (unless the issuer of the asset not selected is of lower quality, or not part of the credit risk allocation).
What solutions are available?
Investors can manage their exposure to interest rate risk by adjusting the sensitivity of their bond portfolio, especially by selecting bonds with a shorter duration.
Holders of short-duration bonds can reinvest their capital in a security with a higher rate of return sooner than investors in bonds with a longer duration. In other words, the longer the duration, the more the value of the bond falls if interest rates rise.
And, just like the company above, derivatives can be used to fully or partially hedge against the risk. Nevertheless, since hedging generates costs, investors generally prefer to handle interest rate risk by building a diversified and balanced investment portfolio.
Case 3: interest rate risk exposure for a bank.
Description:
Interest rate risk is a normal part of banking and can be a source of profitability when properly managed. Yet, excessive exposure to interest rate risk poses a threat to both the bank's capital and profitability.
A bank with a rate gap - a gap between floating-rate uses and sources of funds - is exposed to interest rate risk like any other company, only with far more at stake because of its business. And that's not to mention the commercial risk for a bank when interest rates are falling.
What are the risks?
While taking advantage of differences in interest rates is fundamental to the business of any bank, we have to remember that fluctuating rates matter not just for a bank’s revenue, but also for its net economic value. The main risk from fluctuations in interest rates for a bank arises from the difference between the rates charged on loans and offered on deposits.
If interest rates increase and the bank funds its long-term loans through short-term deposits, it could face big losses since it would earn less interest on its long term loans than it would pay customers on the short-term deposits.
If there was a sharp drop in interest rates, the bank could struggle to protect its margin, which consists of the extra credit margin on loans granted to customers. These few basis points account for an increasingly large share of the total interest rate offered to its customers and competition between banks puts intense pressure on these rates.
What solutions are available?
Like our company and our investor, the bank can use financial derivatives to hedge this risk to optimise its interest rate gap, while remaining compliant with regulations on capital requirements and other banking directives.
Lastly, it is up to each bank to find the right business model with the right mix of offers for its customers to protect its commercial margin.
