Market and currency volatility inevitably leads to interest rate risk. Where this threatens to impact profitability it has to be effectively managed. What does it entail for treasurers operating in Asia?
Just as there may be a whole new generation of bankers who have yet to work in a rising interest rate environment, so there must be a number of new treasurers who are yet to experience the vagaries of interest rate movement. But it will happen sooner or later and whichever direction interest rates take (China possibly downwards, the US possibly up), companies failing to take informed action (even if that means doing nothing) are taking a huge financial risk.
According to CPA Australia, the country’s professional accounting body, interest rate risk should be managed where fluctuations in interest rates impact on the organisation’s profitability. In its publication, ‘Understanding and Managing Interest Rate Risk Finance & Treasury’, it states that action should be taken “so that the focus of the organisation is on providing the core goods or services without exposing the business to financial risks”.
In essence, interest rate risk arises from the exposure of a company’s financial activities to negative movements in interest rates. The proper management of that risk by a business is not about trying to stop rate movements (because in general this is not possible) but is instead about maintaining that risk exposure somewhere within the pre-agreed boundaries of what is acceptable. However, as with most variable factors in modern commerce, what is tolerable for one company may not be so for another. Because the influencing features of risk management (such as risk appetite, nature of business and capital structure) are different for each participant, there can be no one-size-fits-all solution. For a treasurer, this means having to understand exposures, grappling with the sources of risk and their possible effects, and then finding, implementing and maintaining the most appropriate means of its measurement and its ongoing management. For those without the experience it could be a bumpy ride.
The connection between interest rates and FX
The Asian markets exhibit a number of different micro-climates largely driven by political economies. But it is easy to forget that interest rates and FX rates are interconnected to the extent that one affects the other. Aside from Japan, China is the major influence on its neighbouring economies. Where that tight interconnectedness of interest rates and currency measures steers the direction of economic movement, it is easy to see why China’s recent profound meddling with yuan (CNY) is of extreme interest to many in the region (and indeed beyond).
Until the middle of last year, CNY was pegged to the USD (within a limited float-range) affording its currency relative stability. Its interest rates were correspondingly unwavering. However, with the devaluation of CNY last year (on 11th August) in response to continuing efforts by the central bank, the Peoples’ Bank of China (PBoC), to shift to a more market-driven system of setting the currency’s rate (as it tries to meet the requirements for the currency to join the International Monetary Fund’s basket of reserves), there has been considerable speculation that China’s currency may start to float with even more freedom against the USD in 2016.
Indeed, China’s economic growth goal of 6.5% for the next five years will not be met unless CNY falls at least 8% against the USD by the end of 2016, according to Royal Bank of Canada and Rabobank Groep. China (like all other developed economies) will most likely use monetary policy (eg the manipulation of interest rates) to try to reverse the effects of its current economic slowdown, resulting in downward currency movement (against the likes of USD, GBP and Euro) and strengthening of its exports. If there is a shift in terms of CNY versus other currencies at the hands of monetary policy enacted by China, it will quite likely have an impact on other economies in the region. There are many overseas corporates with major business interests in the region and if interest and FX rThe kind of action to be taken will come aates do move as expected, decisions will need to be made about the response: falling interest rates in China lowers prices, local revenues will drop aThe kind of action to be taken will come accordingly and costs will have to be taken out somewhere.
Some sources of risk
It is obvious that companies with floating rate debt are negatively exposed to increases in interest rates, whereas companies with borrowings which are totally or partly fixed are exposed to falls in interest rates. However, bond prices always move in the opposite direction to interest rates, so any rise will decrease their value. This may seem counter-intuitive, but newly issued bonds will reflect the new higher rate so that pre-existing bonds will have to re-price downwards to offer investors the same yield. Although a non-financial firm will usually report its bonds on issue in financial statements at levels often different to their face value, early redemptions must be done at market value which may be significantly different because interest rates change the value of fixed-rate debt. It is the case too that a pension scheme also faces interest rate risk in that its liabilities act in a similar way to bond value, falling in value as interest rates rise (and vice versa).
Derivatives (such as interest rate swaps, futures or options) are impacted by interest rate changes, representing either an opportunity gain or loss (if the transaction is finalised on maturity). An FX forward, where rates are affected by the differential between domestic interest rates and foreign rates, may for example see an increase in the domestic rate relative to offshore rates in which case the cost of hedging imports will rise as the cost of hedging exports falls.
Made to measure
In seeking to mitigate interest rate risk, first of all, it should be understood that regardless of the system of measurement, the results achieved – and thus the efficacy of that system – hangs entirely on the validity of the underlying assumptions and the accuracy of the basic methodologies used to model interest rate risk exposure. This observation from the Basel Committee on Banking Supervision, from its publication, ‘The Principles for the Management and supervision of Interest Rate Risk’, is aimed principally at banks subject to Basel II, but is nonetheless wholly relevant for treasurers.
The document (currently under discussion for Basel III enhancement) stresses further that when designing an interest rate risk measurement system, those responsible “should ensure that the degree of detail about the nature of their interest-sensitive positions is commensurate with the complexity and risk inherent in those positions”. As an example, when using gap analysis to explore exposures, “the precision of interest rate risk measurement depends in part on the number of time bands into which positions are aggregated”. The aggregation of positions/cash flows into broad time bands implies some loss of precision and, in practice, the organisation using this system “must assess the significance of the potential loss of precision in determining the extent of aggregation and simplification to be built into the measurement approach”. The integrity and timeliness of data on current positions is, it adds, a key component of the risk measurement process.
Risk management and more
In the context of interest rate risk management, the role of the treasurer is to focus on possibilities – asking what can possibly happen and how can the company protect itself and secure an acceptable degree of certainty in the circumstances. Treasury therefore needs to be prepared for any possibility so that the business is not seen to be gambling with the turn of events. In the first instance, such preparedness requires the ability to know and understand exposures in all entities, including subsidiaries. The use of simple spreadsheet tools may provide a broad measurement of the impact of small changes of interest rates on a firm’s accounting income, but might not be the optimal approach when attempting to understand more fully what the impact is of rate changes on those exposures.
For this reason, it may be prudent for an organisation to deploy a more technologically advanced assist, integrating their ERP systems with their TMS perhaps to gain more automation of processes and thus more certainty around the accuracy of analysis of interest rates (and of course the interlinked FX movements). The actual tools used will depend on the level of exposure but it can be an arduous and inefficient exercise if treasury is spending a lot of time trying to recreate formulae and testing spreadsheets to assess the potential impact on a variety of factors and variables of movement in interest and accompanying FX rates; this may be a driver for the acquisition of new technologies.
If the appropriate sensitivity analysis models are in place, the right data is readily available and the business knows its exposures, then the process can be relatively straightforward for most operations. It may be desirable to implement more advanced means of measurement of the impact of multiple hypothetical interest and FX rates changes on cashflow, capital and future earnings. But as long as the organisation understands what is going to happen to it if interest rates shift then its vulnerability potentially decreases. It must therefore measure that vulnerability under stressed market conditions. A part of this process is to analyse the effect of the breakdown of core assumptions around the market, creating a number of stressed ‘what-if’ scenarios. Whether the rate shift is immediate and sustained, gradual, parallel (all maturities on the yield curve change by the same amount) or whether it shifts more at the back end of the yield curve where there may be less exposure, the key always is to understand at different points in time what the effect of change is. Large organisations with exposures going out months and probably years must undertake proper analysis covering all points in that period.
Instruments of protection
There are many ways that interest rate risk can be managed. The simplest method is when the borrower requests its lender to fix the interest rate of its loan for the period of the loan, although this has its own inherent risk if rates fall. Natural hedges may be used where interest rate exposures are created that are offset by elements of the company’s natural business cycle (a construction firm, for example, will see a rise in business activity when interest rates fall, as investors build more when the cost of projects is lower). Also many companies that wish to hedge macro-level interest rate risk will use instruments such as interest rate swaps. These are simple to understand and tend to be favourably treated from an accounting perspective making them relatively easy for treasury and accounting to comply with from a regulations standpoint.
The kind of action to be taken will come about following the determination of the appropriate risk appetite for the organisation and its stakeholders. Every business should have drafted and implemented a guiding policy.
Slightly more complex is optionality within instruments such as swaptions (the right but not the obligation to swap), bond forwards (where the short position agrees to deliver pre-specified bonds to the long position at a set price and within a defined time window), interest rate futures (allowing the buyer and seller to lock in the price of the interest-bearing asset for a future date). Caps, floors and collars are commonly used ‘over-the-counter’ (OTC) products. Caps fix the interest rate payable by a borrower over its life and below the cap level, the interest rate payable is floating. The main use is by borrowers who need to avoid covenant breaches that would otherwise be caused by sharp rises in rates. A floor is an option that fixes the minimum interest rate receivable over its life; treasurers with cash invested might buy a floor that is lower than current interest rates to set a minimum return. Collars set a corridor of possible interest rates between a maximum and a minimum. As with FX options, it is also possible to start combining different derivative positions into larger strategies.
Arguably interest rate management does not need to be complex and that the plain vanilla instruments work when protecting against macro-level interest rate exposure. And whereas FX management tends to require a more reactive response because it constantly changes, interest rate changes are fewer and further between and are more predictable, giving time for a considered response. But whilst treasurers will not be constantly putting swaps on and taking them off in response to events, rate movements can be more impactful when they do occur and cannot be ignored.
A matter of policy
Managing interest rate risk suggests that certain actions must be taken, but of course it may be that doing nothing is the best approach. This can only be confirmed if the business has the right analysis, drawn from the most appropriate and timely information. Treasury does not necessarily need to hedge to protect against interest rate movements, it just needs to know what to expect and to set those expectations with the company’s senior executives, board and shareholders. It is also the case that every set of financial statements (for IAS, IFRS et al) ask for the kind of analyses that can show the impact of certain percentage changes in interest and FX rates as a demonstration of risk management visibility and transparency to the investment community.
The kind of action to be taken will come about following the determination of the appropriate risk appetite for the organisation and its stakeholders. Every business should have drafted and implemented a guiding policy – certainly where the use of financial instruments is required to manage interest rate risk – and this will hopefully be an informed decision based on close study of the variables that the business is affected by. Of course, the decision points will be different for each organisation based on circumstances and stakeholder expectations but a heavy borrower will be more sensitised to changes in interest rates than one which tends to invest more.
According to the Basel Committee, policy should define those responsible for managing interest rate risk and should ensure that there is adequate separation of duties in key elements of the risk management process “to avoid potential conflicts of interest”. Additionally, it advises that interest rate risk should be monitored on a “consolidated, comprehensive basis, to include interest rate exposures in subsidiaries”.
The efficacy of the policy document should be reviewed on a regular basis. If analysis highlights company exposures at a macro and micro level for each component of the business, then it will enable the treasurer to make the best possible decisions. This level of understanding should also be seen as an opportunity for treasury to proactively engage in continued discussion with the rest of the business and its key stakeholders, helping to steer future policy direction.
A stale policy – one that has not been appropriately updated – around any form of risk management puts the company in a position where it may not be aligned with the reality of the market place: this is a dangerous scenario. But in the context of interest rate risk it is not just the actual rate movements which could negatively impact a business: any expansion into new territories or markets that have different interest rate profiles from existing market activities could upset the validity of existing underlying assumptions and the modelling accuracy of interest rate risk exposure. It is important to understand that the realities of the business and where it operates will determine what its overall exposure is and thus what its risk management policy should be.
The response to rate movements is therefore not just about the making of assumptions but also about validating those assumptions, being prepared with an accurate view of what the outcomes will be across the business and, ultimately, taking the appropriate decision to ensure the business is protected.
