Chapter 5 Interest Rate Risk Management – Essentials of Financial Risk Management

CHAPTER 5

Interest Rate Risk Management

Effects of Interest Rate Risk

Variability of interest rates affects a firm in a wide variety of ways. The most obvious one is on the firm’s cost of debt. However, there are many other secondary effects in which interest rate affects the financial results of a firm.

As interest rates rise, the cost of equity financing also rises. Additionally, the availability of equity financing diminishes as debt becomes a more attractive investment asset for investors. As debt and equity costs rise, the weighted average cost of capital for the firm will also rise. An increased weighted average cost of capital can significantly alter the strategic plans of the firm by leading to fewer growth projects being accepted and a level of underinvestment overall in the firm.

Relative to the direct costs of debt and equity, interest rates may also affect the availability of financing and the flexibility that firms have in setting the terms and conditions of the financing. This was seen as a prime example during the 2008 financial crisis when even highly rated firms had difficulty securing financing as investors retreated to holding cash.

Many companies also find that interest rates significantly affect demand for the goods and services of their firm. Each firm should have an understanding of its interest rate sensitivity of its sales. Particularly for consumer goods that are typically bought on credit—automobiles as one example—interest costs may play a significant role in affecting sales volatility.

Another direct effect of interest rate changes is the change in credit risk and the potential for bankruptcy; not only bankruptcy of the firm, but also the credit risk or bankruptcy of its customers and suppliers. As interest rates rise, highly leveraged firms come under more scrutiny. The rising potential for bankruptcy has implications for the firm’s ability to attract top-level talent, the firm’s ability to maintain the faith of its customers, as well as implications for its relationships with its suppliers. This is to say nothing of the direct costs of bankruptcy and the reputational damage incurred.

Management of interest rate risks is thus one of the most common concerns of financial managers and by extension the various stakeholders in the firm. Successful interest rate management helps a firm maintain its good financial health as well as its reputation, which in turn improves its focus on the main strategic objectives of the firm rather than worrying about changing rates which ultimately are out of its control.

Capital Structure Management

The most straightforward mechanism to manage interest rate risk is with thoughtful management of the capital structure of the firm. Maintaining an appropriate capital structure in light of interest rate risk should be a central concern of the financial management—and of the Board. Too often, however, the focus of capital structure is on the current costs of capital or on the accessibility of capital. Although cost and availability are important considerations when developing the capital structure of the firm, they are just two of many concerns that should be taken into consideration. Risk management and flexibility should be given equal weighting when deciding what the next form of capital raising will take. Frequently going for the most expedient lowest cost form of financing can turn out to be very expensive and costly in the long run when risk considerations are taken into account.

The most basic risk concern is debt versus equity as the form of financing. While debt is obviously the less expensive form of financing, the risks of too much leverage and bankruptcy can become all too real, and all too quickly. Higher levels of leverage diminish the financing flexibility of the firm, and particularly so when interest rates rise.

Related to the level of debt financing is the type of debt financing; fixed versus floating rate debt, and short-term versus long-term debt. The cost structures of these two debt financing decisions have a direct relation to the amount of interest rate risk they carry for the firm. Fixed rate debt is obviously less sensitive to interest rates, but because of this lower volatility it also carries a higher average interest cost than floating rate debt. Likewise, long-term debt is also generally more expensive than short-term debt.

Short-term debt has two major components of interest rate risk. The first is the simple fact that short-term debt has to be sourced more frequently. This means that there is a higher likelihood that it may be unavailable when needed. This was certainly the experience of many companies during the 2008 financial crisis when sources of both short-term and long-term debt financing dried up and firms that were financing themselves with short-term debt found it nearly impossible to roll over their debt or refinance with other sources. The second risk is that although short-term debt is generally lower in cost than long-term debt, the variability of short-term debt is much greater than long-term debt. If one examines the historical yield curve, one finds that long-term yields are relatively stable, while short-term yields tend to fluctuate much more significantly. Thus, while short-term debt is less expensive, it adds to the interest rate sensitivity significantly. With long-term debt, the firm will have locked-in its financing. Financing with short-term debt implies that the firm is going back to the market more frequently, and thus will be more exposed to interest rate volatility.

Case Study

Asset Backed Commercial Paper and the 2008 Crisis

The financial crisis of 2007 to 2008 which led to the great recession highlighted many previously unknown or at least underappreciated risks. One such risk arose in the asset backed commercial paper (ABCP) market in Canada, although similar situations were faced in commercial paper markets around the world. ABCP is a short-term debt instrument issued by financial institutions with short maturities up to 1 year, but often for only 30 to 60 days. The issuing entity bundles together, in a special purpose vehicle, an assortment of income generating assets such as credit card loans, mortgages, or auto loans. These assets act as collateral which generally makes these loans very low risk, receiving high credit ratings from ratings agencies, and keeping interest rates low. As the loans mature they are usually rolled over very easily, but unlike traditional bond issues which may have maturities of 5, 10, or even 30 years, ABCP must be rolled much more frequently. Investors buy these securities in part because they are only tying their money up for a month or two. Maintaining investor confidence is critical for issuers of ABCP. In 2007, as the subprime crisis in the United States began to take hold, investors began to avoid mortgage-backed securities (MBS) and soon were shunning anything that may be remotely related to the subprime market. It became difficult at best and at times impossible to value many mortgage- and housing-related securities. As the visibility into the assets within these securitizations is limited, investors were unsure what exposure they may have to subprime mortgages and what this could mean for the value of the securities. Investors at first reacted by demanding higher interest rates on these securities to compensate them for this perceived higher risk, but soon the market for ABCP in Canada froze up almost entirely and it became impossible for issuers to roll over their paper. Without new buyers for ABCP, issuers had very little time to find alternative funding and default appeared likely and would have triggered a disorderly liquidation of the underlying assets, at significantly depressed prices. To avoid this, a plan was created to exchange the short-term ABCP for new securities with much longer maturities of up to 9 years.1

In the end, it turned out that Canadian ABCP had a relatively small exposure to U.S. subprime mortgages, but the fear and uncertainty that gripped the market at the time cast a broad shadow over the entire ABCP market. The entire commercial paper market, including securities issued by creditworthy utilities and other firms well outside U.S. subprime saw buyers for their paper disappear, cutting off a crucial source of short-term financing. In Canada, the story had a relatively happy ending; in early 2017, the last of the investors in the restructured notes receiving their money back.2 This isn’t to say that nobody lost money—after the initial crisis when a market developed for the restructured notes, many original investors sold their holdings at a discount of up to 60 percent from face value, often to hedge funds looking for a bargain.3

What lessons can we take from this experience? Firstly, ABCP and other similar products are complicated and often opaque investments. Spending time and effort on appropriate due diligence to fully understand the details of the product and the risks involved can be well worth it. In addition to the individual investment, understanding the market dynamics surrounding the product is important as well. What factors in the market and the broader economy can impact the investment’s value or its liquidity, in other words could something happen that would prevent the investor from being able to exit its position quickly without being forced to take a big haircut from fair value. Lastly, issuers of these securities need to be cognizant of market dynamics as well. A firm may be completely confident in the value of the assets underlying ABCP, but when panic hits the market, their securities may be painted with the same brush as paper stuffed with the worst subprime mortgages around. Ensuring that other sources of funding are available should short-term credit markets seize up may prove to be a very worthwhile activity in times of panic.

Know what you are investing in.

Understand the market dynamics and how you can be impacted—even indirectly.

Ultimately, the question of interest rate sensitivity and financial leverage in the capital structure comes down to the business risk of the firm. In this context, business risk is the volatility of the firm’s revenues and expenses to overall economic trends. Some firms and some industries are relatively immune from economic cycles—the pharmaceutical industry as one example. Other industries which deal in discretionary goods—such as fashion—are much more sensitive to the economic cycle and thus carry more inherent business risk. As a general heuristic, the greater the business risk of the firm, the less financial risk and interest rate risk the firm should carry through leverage.

Managing Interest Rate Risk

As with most other types of financial risk, there are two main types of instruments for dealing with interest rate risk (beyond the capital structure decisions discussed in the previous section). Firms can use forward type products called swaps, or they can use option type products such as caps and floors. In addition, forward rate agreements (FRAs) and futures contracts that can be used to hedge a one-time interest rate exposure such as an anticipated future debt financing.

Interest rate swaps are a staple of the financial risk manager’s tool box. An interest rate swap effectively changes a floating rate liability, such as floating rate debt, into a fixed rate liability. Figure 5.1 illustrates the basic workings of an interest rate swap.

Figure 5.1 Illustration of an interest rate swap

Dashed lines show floating rate payments, while solid line illustrates fixed rate payments.

For purposes of illustration, assume that a company has floating rate debt outstanding that is tied to an interest rate index such as LIBOR. Assume that the interest payments on the loan are semi-annual and that the loan has a fixed term of 5 years. Also assume that the firm is paying a floating interest rate of LIBOR plus a credit spread of X basis points. To hedge against the risk of interest rates rising, the bank could enter into a 5-year swap with a financial counterparty, and agree to pay a fixed rate S (multiplied by the notional of the swap) and receive a payment based on the LIBOR rate (multiplied by the notional of the swap). The rate S is called the swap rate. The timing of the semi-annual swap payments, as well as the notional amount of the swap, should be set to coincide with the interest payments on the loan.

The net effect of the swap is that the firm is now paying an all-in interest cost of S plus whatever the credit spread X on the loan is. In effect, the company has transformed their floating rate debt into a fixed rate exposure; they have eliminated interest rate risk due to the floating LIBOR rate. If interest rates increase, the increase in the cost on the loan will be offset by the increase in the payments by swap counterparty. However, note that if interest rates decrease, then the company will be making payments to the swap counterparty. As with all forward type products, a swap fixes the exposure so the amount paid is constant. Thus, a swap is a positive when rates go higher, but it is a negative and involves higher net interest costs if rates fall than would occur without the swap.

An alternative to a swap is an interest rate cap. An interest rate cap is effectively like a series of call options on the interest rate. If interest rates rise above a preset level, then the firm will receive a payment from the counterparty. However, unlike with the swap, if interest rates fall, the firm will not have to make payments to the cap counterparty but instead will be able to take full advantage of the fall in interest rates. Figure 5.2 illustrates this.

Figure 5.2 Illustration of an interest rate cap

Interest rate cap counterparty makes payment if LIBOR greater than cap rate.

The cap level and the notional amount would be determined upfront. As with the swap, the notional amount would be set equal to the size of the loan. The cap periods, or reset dates, should also be set to coincide with the payments on the loan. For each of the reset dates that the index interest rate is above the cap rate, the counterparty would make a payment to the firm equal to the difference in rates multiplied by the notional amount. This payment could then be applied to the loan payment, thus effectively “capping” the all-in interest cost on the loan at the cap rate plus the credit spread. Note, that if at the reset date the prevailing interest rate is below the cap rate on the reset date, then no payment on the cap occurs. However, in this situation, the firm would be benefiting from lower rates (the rates are below the cap rate), and thus making a smaller interest payment than the cap rate on their loan.

One disadvantage of an interest rate cap is that it involves an upfront cost as it is essentially a series of call options on the interest rate. Generally, an interest rate swap does not involve an upfront cost. To help offset, or potentially totally offset the cost of the cap, a company may choose to enter into an interest rate floor at the same time that they enter into an interest rate cap.

An interest rate floor is like a series of put options on the interest rate. If the interest rate at the reset date is below a specified level, called the floor level, then the company will make a payment to the counterparty equal to the amount that the rate is below the floor level, multiplied by the notional amount of the floor. A company that wishes to buy a cap, can in part, or sometimes in whole, offset the cost of the cap by selling an interest rate floor. This is generally done with the same counterparty that the company has entered into the swap with. The combination of an interest rate cap and an interest rate floor is called an interest rate collar.

For purposes of illustrating an interest rate collar, consider the situation shown in Figure 5.3. For purposes of illustration, assume that the firm has a loan that has an interest rate of LIBOR plus 2 percent. To hedge against interest rates rising, the company decides to enter into an interest rate cap that has a cap rate based on the LIBOR index of 8 percent. To at least partially offset the cost of the cap, the company decides to sell an interest rate floor with a floor rate of 3 percent. The notional amount of the cap and the floor is the same as the size of the loan, and the reset dates of the cap and of the floor also match the reset dates of the loan. Whenever LIBOR is above the cap rate of 8 percent, the collar counterparty will make a payment to the company. Likewise, if the LIBOR rate is below the floor rate of 3 percent, then the company will make a payment to the collar counterparty. If the LIBOR rate is between the floor rate and the cap rate, then no payments will be made.

Figure 5.3 Interest rate collar

When the collar payments are considered along with the loan payments, then it should be easy to see that the maximum all-in effective interest rate the firm will pay will be the cap rate of 8 percent plus the 2 percent credit spread for a maximum all-in cost of 10 percent. Likewise, the minimum all-in cost that the company will pay will be the floor rate of 3 percent plus the credit spread of 2 percent, for a total all-in minimum rate of 5 percent. Thus, the company has “collared” its all-in effective interest cost between 5 and 10 percent.

After swaps, the next most important interest rate risk management tool is a forward rate agreement. Forward rate agreements, commonly called FRAs, are a forward contract for a specific date. FRAs, like other forward agreements, allow the company to lock in an interest rate over a specific period of time. It is important to note that an FRA is not an agreement to lend (or accept a deposit) at a given rate. Instead, it is a contract that makes a payment between the realized interest rate and the rate that was agreed upon at the inception of the contract. However, this payment, when combined with an actual borrowing will create a locked-in rate just as a swap does. Perhaps, the easiest way to think of an FRA is that it is essentially just like a single resetting of a swap. If at the time of the maturity of the FRA, the index rate is above the FRA rate, then the counterparty will make a payment to the company. Conversely, if the index rate is below the FRA rate, then the company will make a payment to the counterparty. The situation is illustrated in Figure 5.4.

Figure 5.4 Forward rate agreement

Note that the payments of an FRA are a one-time payment. Thus, FRAs are generally used for short-term loans such as loans to cover a seasonal working capital shortfall.

Futures on forward borrowings are also available on the exchanges. The most popular is the eurodollar futures which is a contract based on the 3-month LIBOR interest rate. When buying a eurodollar futures contract, one is conceptually (not actually) agreeing to enter into a lending agreement for a 3-month period. The notional amount is US$1MM. The price of the eurodollar future is equal to 100 minus the yield. Thus as yields go up, the price of the eurodollar futures contract falls. A one basis point change in the 3-month yield implies a change in value of each futures contract of $25 which would be the change for a $1MM borrowing for 3 months if there was a 0.01 percent change in the interest rate; ($1,000,000 × 0.01% × 3/12).

Although eurodollar futures contracts are some of the most frequently traded exchange traded products, they generally are not used by corporations in their hedging activities due to the standardization of the exchange traded product. However, eurodollar futures contracts are heavily used by the financial intermediaries who do offer forward contracts to corporations. These intermediaries use these contracts to essentially engineer the forward contracts they offer to corporations.

The exchanges also offer longer-term futures contracts and option contracts for managing longer-dated interest rate risk. Treasury Bond futures and options are contracts that are based on the theoretical price of long-dated Treasury Bonds, with the most popular being the 5-year and the 10-year Treasury Bonds. Conceptually, when buying Treasury Bond futures or options, one is entering into an agreement to buy the underlying Treasury Bond. Since the value of Treasury Bonds changes with interest rates, the value of the futures contract will also change with interest rates.

Treasury Bond futures and options are generally used to hedge against rising interest rates when the company is considering issuing long-term debt or undertaking a long-term loan. If interest rates rise before the company sources its debt financing, then the value of the Treasury Bond will have fallen in value. In turn, this implies that the value of the Treasury Bond futures contract will have also fallen. The company can thus hedge by selling Treasury Bond futures contracts providing an offset to the increased cost of the debt financing. There are a few caveats when using exchange traded Treasury Bond products. To facilitate trading, there are a few operational details that complicate calculating the appropriate size of the hedge required. Specifically, there are a large number of Treasury Bonds that could be used to satisfy the physical delivery of the futures contracts and this leads to what is known as the “Wild Card Option.” The exchange has in place rules, and an adjustment formula, to ensure that all contract holders are treated fairly. The details are beyond the scope of this book, but the reader is advised to check on the details before using exchange traded Treasury Bond contracts.

Exchange traded contracts, both eurodollar contracts as well as Treasury Bond contracts, are useful indicators of expected interest rate volatility. Although they are not perfect indicators of future interest rates (changes in the current interest rate is perhaps a better indicator), the exchange traded contracts do offer an indication of the market’s view of expected changes. Knowledgeable risk managers closely follow the futures markets to develop their own sense of interest rate risk.

Concluding Thoughts

Interest rate risk is central to almost any corporation. Interest rates affect an organization’s funding costs, and also for many companies affect the level of their sales and their profit margins. Successful management of interest rate risk can provide a significant competitive advantage. There are a variety of ways an organization can manage its interest rate risk. It can do so through the way that the organization chooses to fund itself, or it can do so through the use of derivatives.

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1T. Perkins. March, 2017. “The ABCs of Asset-Backed Commercial Paper.” https://www.theglobeandmail.com/report-on-business/the-abcs-of-asset-backed-commercial-paper/article1053871/

2J. Paterson. January, 2017. “What Are the Lessons Learned as Big Investors Finally Get ABCP Money Back?” http://www.benefitscanada.com/investments/asset-classes/what-are-the-lessons-learned-as-big-investors-finally-get-abcp-money-back-92622

3Bloomberg News. March, 2015. “How Some Investors Raked in Huge Returns on the ABCP Collapse Wreckage.” http://business.financialpost.com/news/fp-street/how-some-investors-raked-in-huge-returns-on-the-abcp-collapse-wreckage