It could be argued that interest rate risk can never be eliminated – only reduced – unless a business has neither debt nor cash, or only in small amounts.
In many businesses, interest rate risk is very much a centralised risk. The operating units don’t influence financing and are measured on operating profit, with no account taken of interest charges.
For some businesses, however, the interest rate is a crucial input cost in much the same way that rent or labour might be for a manufacturing business. For example, airlines use expensive assets where the interest rate is a large component of leasing or financing costs. Customers ultimately must pay for any higher interest costs, assuming that they still want to travel.
Before we can consider a response to interest rates, we need to work out what is important to our business
Interest rate risk within a pension scheme is another aspect of interest rate risk. But it is possible to eliminate risk in a scheme, even if it presents many practical difficulties.
In private equity and similar situations, such as project finance or infrastructure projects, the return calculations (of which debt cost is one) can make a deal succeed or fail.
Finally, we must remember margin risk. Margin (the interest paid over the base of Libor, treasuries, etc) can bear as much risk as the underlying interest rate. Note that the classic responses to interest rate risk don’t usually address margin risk.
A business may do better or worse depending on whether interest rates rise or fall. So it is important to consider any such possible link when managing the risk. Remember that governments tend to reduce interest rates in times of recession.
We often measure interest rate risk by seeing what happens with a change in rates, say up 1bp or up 1%, reflecting a parallel shift of the yield curve. (See Figure 1.) But interest rate risk is complex since the yield curve can move in many ways. (See Figure 2.)
One approach to measuring interest rate risk is to use an implied volatility from the interest rate options market and model what the business might look like under the range of scenarios predicted by the market. A higher volatility in interest rates points to higher interest rate risk.
Before we can consider a response to interest rates, we need to work out what is important to our business since this will lead us to a possible response. (See Table 2.)
A response to interest rate risk is often a simple fixed/floating ratio. It is not always clear what that is trying to achieve, however. It is far better to manage such a ratio with a particular aim in mind. The fixed/floating ratio is typically managed with interest rate swaps. Many studies have shown that, over long periods, floating rates are cheaper than fixed rates.
Finally, you should ask yourself: “What does my business look like if interest rates are X%?”
Will Spinney is associate director of education at the ACT
