INTEREST RATE

RISK
MANAGEMENT
 INTEREST RATE RISK
MANAGEMENT
Interest Rate Risk is the possibility of a change in interest rates that has a
negative impact on a company ’ s profi ts. A company incurs interest rate
risk whenever it borrows or extends credit. This is a serious issue for
companies with large amounts of outstanding debt, since a small hike in
their interest expense could not only have a large negative impact on their
profi ts, but possibly also violate several loan covenants.
 INTEREST RISK
MANAGEMENT OBJECTIVES
• Safeguard company profits by optimizing borrowing rates.
• Mitigate cash flow vulnerabilities through strategic interest rate
exposure management.
• Reduce short-term interest rate volatility for meeting budgeted
financing targets.
 INTEREST RISK
MANAGEMENT STRATEGIES
Internal Techniques

Cash Netting- Optimize cash flow by netting across the company, preventing
excess investments in one area while another subsidiary needs to borrow.
Intercompany Netting Center- Reduce payment transactions between related
companies to streamline operations.
RISK MANAGEMENT LEVELS

Full-Cover Hedging - Eliminate all exposure through hedging positions.

Selective Hedging - Set predetermined minimum and maximum risk levels, allowing
some flexibility. Naked Position - No risk management, either intentional or due to a lack
of understanding of hedging.
Speculative Positions - Reversing underlying exposure; not recommended due to
increased risk and potential misalignment with operational goals.
 FORWARDS
The primary strategies for interest risk management are the use of Forwards,
Futures, and Options.

A Forward Rate Agreement (FRA) is an agreement between two parties to lock

in an interest rate for a predetermined period of time. Under the FRA
agreement, a borrower wants to guard against the cost of rising interest rates,
while the counterparty wishes to protect against declining interest rates.
 FUTURES

An Interest Rate Future is an exchange - traded forward contract

that allows a company to lock in an interest rate for a future time
period.
 OPTIONS

An options contract grants the buyer the right to buy or sell a specified
amount of futures contracts at a future date.
The associated cost is the options premium, paid upfront to the counterparty.

Types of Options
Call Option - Shields the buyer from rising interest rates.
Put Option - Shields the buyer from declining rates.
 INTEREST RATE SWAPS
Interest Rate Swaps involve two parties, usually banks, exchanging interest payments
over a fixed time period, typically ranging from 1 to 10 years. One party pays a fixed
interest rate, while the other pays a variable rate. Companies can shift between fixed and
variable payments, better forecasting financing costs and avoiding increased payments.
They are particularly useful for companies with weak credit ratings who need to obtain
fixed-rate debt. The parties deal directly with each other using the standard master
agreement maintained by the International Swaps and Derivatives Association (ISDA).
 DEBT CALL PROVISIONS
If a company is issuing its own debt, it can include a call provision in the debt instrument that allows the
company to retire the debt at a predetermined price. A treasurer would take advantage of this provision if
market rates were to decline subsequent to issuance of the debt, and could then refinance at a lower interest
rate. The call provision typically incorporates higher prices for earlier calls, which gradually decline closer to
par pricing further into the future. This higher initial price point compensates investors for the interest income
they would otherwise have earned if the company had not called the debt. Also, a call provision limits a bond’s
potential price appreciation to the amount of its call price, since the issuer will then call the bond.
Consequently, the call provision is useful to a company by allowing it to buy back expensive debt and reissue
at lower rates, but only if the savings from doing so exceed the amount of the call price.
 INTEREST RATE SWAPS

For example, ABC Company could issue bonds with a call provision that allows
it to buy back the bonds at 105 percent of par value after two years, then again at
103 percent of par value after six years, and then at their par value after eight
years.
Several risks to be aware of when entering into swap agreements:

Basis Risk - This is caused by the mismatch between the cash flows involved in a swap.
Counterparty Risk - One of the parties to a swap agreement may not meet its financial
obligations.
Legal Risk - One of the parties to an over-the-counter transaction may have incorrectly or
incompletely filled out a contract, or the signer of it may not have been authorized to do
so.
 SWAPTIONS

A Swaption is an option on an interest rate swap. The buyer of a swaption has the right, but
not an obligation, to enter into an interest rate swap with predefi ned terms at the expiration
of the option. In exchange for a premium payment, the buyer of a swaption can lock in
either a fixed or variable interest rate. Thus, if a treasurer believes that interest rates will
rise, he can enter into a swaption agreement, which he can later convert into an interest rate
swap if interest rates do indeed go up.
 SWAPTIONS
Example:
The Shapiro Pool Company needs to finance its construction of the pool complex for the
Summer Olympic Games. It expects to do so at the floating LIBOR rate plus 1.5% in six
months, with a duration of three years. To protect itself from rates increasing above 7.0 percent,
Shapiro buys a swaption.

The swaption agreement gives Shapiro the right, but not the obligation, to enter into an interest
rate swap where it pays a fixed rate of 7.0 percent and receives LIBOR plus 1.5%. If the
reference rate in nine months is above 7.0 percent, then Shapiro should exercise the option to
enter into the swap.
 COUNTERPARTY LIMITS

Companies using risk management strategies, such as FRAs, swaps, and collars, are
subject to limits set by banks, their usual counterparties. These banks establish
counterparty limits for each company, reducing the available limit every time an
agreement is made. This means that as a company engages in more of these agreements,
the risk strategies outlined may become unavailable beyond a certain activity level.
 INTEREST RISK MANAGEMENT
CONTROLS

Companies using risk management strategies, such as FRAs, swaps, and collars, are
subject to limits set by banks, their usual counterparties. These banks establish
counterparty limits for each company, reducing the available limit every time an
agreement is made. This means that as a company engages in more of these agreements,
the risk strategies outlined may become unavailable beyond a certain activity level.
 INTEREST RISK MANAGEMENT
CONTROLS
There are a variety of controls that the treasury department can implement in order to reduce the risk profile
of its hedging activities. These controls are divided into ones that can be used for all types of hedges, and
those that apply specifically to cash flow hedges.

Hedges — General
• Determine counterparty creditworthiness. When a company plans to engage in over-the-counter hedging
transactions with a direct counterparty (instead of through an exchange), the treasurer should assess the
counterparty's creditworthiness beforehand. This is crucial to avoid the risk of the counterparty being
unable to fulfill its obligations under the contract.
 INTEREST RISK MANAGEMENT
CONTROLS
• Verify contract terms and signatory. If a counterparty fails to correctly fill out an over-the-counter
contract or the person signing isn't authorized, the company may struggle to enforce payment. The
company's legal department should address these concerns when overseeing the signing of new
contracts.
• Include in the hedging procedure a requirement for full documentation of each hedge. To comply
with generally accepted accounting principles (GAAP), hedging transactions must be fully
documented from the start. Ensuring compliance involves including the documentation
requirement in the accounting procedure for creating hedges.
 INTEREST RISK MANAGEMENT
CONTROLS
• Confirm all hedging transactions. After a hedging deal is done, someone other than the initiator
should confirm the details by matching the company's transaction with the counterparty or
exchange. This confirmation can be done through a written or electronic message.
• Reconcile accounts. The treasury team should monthly compare debt and investment accounts
with counterparty balances. If a significant issue arises, the control should allow for immediate
reporting to higher management. Additionally, the internal audit staff can conduct occasional,
unscheduled reconciliations for further review.
 INTEREST RISK MANAGEMENT
CONTROLS

• Full-risk modeling. The treasury team should perform comprehensive risk modeling
for investments and debt every quarter. This helps assess the potential risk in the
unhedged portfolio and evaluate the company's historical gains or losses without
hedging transactions on a rolling basis.
 CASH FLOW HEDGES
• Include in the monthly financial statement procedure a review of the recoverability of cash flow hedge
losses. According to GAAP, if there's a nonrecoverable cash flow hedge loss, it must be moved from
comprehensive income to earnings in the current period. As this may decrease earnings, accounting
personnel may avoid the review. Adding this step to the monthly procedure ensures timely recognition of
losses.
• Include in the monthly financial statement procedure a review of the likely occurrence of forecasted cash
flow transactions. According to GAAP, any gain or loss in comprehensive income should move to earnings
when it's likely that the expected cash flow transaction won't happen. Adding a regular review of forecasted
transactions to the monthly procedure ensures timely inclusion of these gains or losses in earnings.
 CASH FLOW HEDGES

• Compare hedging effectiveness assessments to the corporate policy setting forth effectiveness
ranges. GAAP doesn't specify the exact offset required between hedging instruments and
hedged items for high effectiveness. To ensure consistency, a corporate policy (refer to the
Policies section) should set this standard. This control ensures adherence to the policy during
effectiveness assessments, with a comparison to the corporate policy included in the
assessment procedure.
 INTEREST RISK
MANAGEMENT POLICIES

The first two policies noted below are designed to introduce consistency into the accounting
for hedges, so that the accounting department will be unable to take liberties with profit
recognition. The final policy provides for a hard credit-rating floor, below which a company is
not allowed to deal with a counterparty whose financial position may be weak. The final
policy is a catchall authorization to avoid counterparties that are too hard to deal with. The
policies are:
 INTEREST RISK
MANAGEMENT POLICIES
• The determination of hedge effectiveness shall always use the same method for similar types of hedges.
GAAP permits various assessment techniques for determining hedge effectiveness. However, changing
methods, even if justified, can lead to variations in reported earnings. To avoid this, establishing and
consistently using a standard assessment method for each type of hedge reduces the risk of assessment
manipulation by the accounting staff.
• A hedge shall be considered highly effective if the fair values of the hedging instrument and hedged item are
at least ___ percent offset. GAAP doesn't provide a specific number for what makes a hedge highly
effective. To address this, a company should establish its own policy defining the level of effectiveness, and
it can use different ranges for different types of hedges.
 INTEREST RISK
MANAGEMENT POLICIES
• The company shall not deal with a counterparty having a credit rating of less than ___. This
policy aims to reduce the risk of a counterparty not fulfilling its obligations in a hedging
agreement. The procedure guides the treasury staff to monitor changes in counterparty credit
ratings, especially those with declining ratings. To be highly effective, a hedge should achieve
at least ___ percent offset in fair values between the hedging instrument and hedged item. Since
GAAP doesn't specify the exact number for high effectiveness, companies should create a
policy to define it, and different ranges can be set for various types of hedges.
 INTEREST RISK
MANAGEMENT POLICIES

• The treasurer has the authority to stop hedging transactions with counterparties that
cause ongoing or significant operational issues for the company. The policy is
intentionally broad, allowing the treasurer to cease business for various reasons, like
improper contract completion, incorrect signatories, or challenges in settling
accounts.
THANK YOU!