At the end of this module you should be able to:
explain what interest rate risk is
identify the sources of interest rate risk
evaluate the implications of interest rate risk management on cash flow
determine the key drivers that impact on interest rate risk management
evaluate the effectiveness and appropriateness of techniques to manage interest rate risk.
interest rate risks
borrowings: risk of rising interest rates
investment: risk of falling interest rates
assets/liabilities: fair value fluctuations
supply/demand: sales volume and value fluctuations
Carsales.com - interest rate risk
The Group's main interest rate risk arises from long-term borrowings. The Group's fixed rate borrowings and receivables are carried at amortized costs. They are therefore not subject to interest rate risk as defined in AASB 7 since neither the carrying amount nor the future cash flows will fluctuate because of a change in market rates.
Quiz. What does the RBA cash rate represent?
the bank bill swap rate (BBSW) 1
the 90 day bank bill futures 2
the overnight money market interest rate
the bank bill swap bid rate (BBSY) 4
BBSW: a short-term interest rate used a benchmark used for pricing securities. It is calculated and published by the Australian Securities Exchange (ASX). Typically the cash rate and BBSW rate are highly correlated.
90 day bank bill futures: a benchmark indicator for short interest rates and is traded at the ASX.
cash rate: the interest rate on unsecured overnight loans between banks. It is set by the Reserve bank of Australia (RBA).
BBSY: a benchmark derived from the BBSW and calculated as the average of the national best bid and best offer. It is usually 5 basis points above the BBSW.
Quiz. How is the RBA real cash rate calculated?
It is the difference between the cash rate and the BBSW
It is the difference between the cash rate and inflation
It is the difference between the cash rate and BBSY
It is the difference between the cash rate and the 90 bank bill futures
Quiz. Which three economies are included in the official policy interest rates of the G3?
Australia, China and the United States
The Euro area, Japan and the United States
Australia, the euro area and the United States
Interest rate drivers
central banks
G3 (forms the benchmark - US, Euro, Japan)
nominal vs real rate (nominal: stated rate, real: nominal - inflation rate)
Yield curve
normal yield curve: increases for longer maturities
inverse yield curve: decreases for long maturities
flat yield curve: remains the same
Interest rate risk management framework
1. set core criteria
role of the board
stakeholder expectation
internal operating environment
external operating environment
risk appetite
set by the board = management input + external environment
general policy - hedge strategy - liquidity risk - funding risk
establishing context
economic environment (yield curve)
organization culture
regulatory environment
competitors and substitutes
SWOT analysis
2. identify the exposures and sensitivities
timing mismatches
embedded options
offsets
commercial adjustments
Quiz. When the value of interest rate sensitive assets maturing in a given period exceeds the value of interest rate sensitive liabilities, what type of gap do we have?
positive (rate sensitive assets > rate sensitive liabilities)
negative (rate sensitive assets < rate sensitive liabilities)
neutral
Maturity profile and timing mismatches
identify maturity profiles for rate-sensitive assets/liabilities
plan ahead for rollovers, repayments and re-pricing adjustments
attempt to match their short-term assets with short-term liabilities, long-term assets with long-term liabilities
understand the effect of yield curves and interest rate movements
Offsets
Primary offset
organizations don't quickly jump into hedging interest rate exposures - they try as much as possible to offset exposure (by considering real derivatives, because they are cheaper than financial derivatives)
embedded options (CPI adjustments, on-charging, price limits)
e.g. if an organization is able to negotiate with a financial institution that if inflation rate increases then we will pass on this cost to the customer = primary offset
commercial (buying/selling, focus on margins, agreements/indexing)
diversification (portfolio theory, business unit exposures, centrally manage exposures)
e.g. Brazil might be operating in a very advanced economy as an example interest rates exposures or interest rates are very unfavorable but you might find that the in the case of Indonesia it could be the exact opposite and so when you bring these business units together you might find that is that our net worth between these organizations and so they the consolidated offset or the overall offset is actually less because of that portfolio because of that portfolio management of all these business units and
assets / liabilities
match your interest sensitive assets with your interest sensitive liabilities
investments
borrowings
Secondary offsets
financial instruments = expensive
Risk analysis
sensitivity analysis: how sensitive is the risk to movements
statistical analysis: what is the most likely outcome?
microsoft excel (goal seek, scenario manager, data analysis - e.g. regression)
3. appraise risks and set strategies
risk rating matrix
benchmarks
contingencies
Risk evaluation
based on likelihood of occurrence
based on impact or consequence
subjective, but aim to be objective
significance of rating determines action (& priority)
consequence table is very tailored to the organization
likelihood stable generally remains the same
Risk rating matrix
Targets and trigger levels
board will set benchmarks
return-based (e.g. ROA)
minimum product margins
trigger levels
determined by plotting potential outcomes
determining rates based on benchmarks
budget rate
minimum return
productivity bonus
Payoff diagrams
what is the current interest rate and cost?
plot the cost/return for rates above and below current rate
mark on Y-axis return target and minimum acceptable OR maximum acceptable cost and target
Timeframe for interest rate risk management (IRRM)
Life of the asset?
asset expired, debt repaid, cost of debt reset
but, hedging long-term assets is expensive
Variability of cash flows?
ability (inability) to pass on changes in interest rates
e.g. electricity retailer with limited pricing authority
Fixed/floating ratio
considerations:
organisation' financial strength
ability to accept/withstand volatility
competitor's hedging policies
board's risk appetite
covenants
financial ratios
meeting objectives
cost of capital
E.g. Fixed hedge ratios:
5 year period
60% fixed
- significant costs (normal yield curve)
- repricing risk (on eventual reset)
E.g. Forward rate calculation:
forward rate for 1-year in 5-years' time
= 3.4559%
r6: today's (spot) 6-year swap rate
r5 today's (spot) 5-year swap rate
the cost of hedging in a normal yield curve setting increases into the future
it is compensating for an extra 0.2% (approx) each year on the 6-year swap rate
4. manage risks
treasury operations
hedging
working capital management
contract management
manage/treat risk
retain risk
remove source
change the likelihood
change the consequence
pass it on
risk management strategies
reduce exposure
protect target profit
remove uncertainty
crisis protection
Quiz. CBF Ltd has $1 million in borrowings on a floating rate and wants to remove uncertainty relating to its exposure to interest rate movements. Which instrument would it use?
an interest rate cap option
a pay-fixed receive-variable interest rate swap
a receive-fixed pay-variable interest rate swap
interest rate swaps
fixed rate is the 'swap rate'
floating reference rate usually the BBSW (or LIBOR in overseas markets)
interest rate swap pay-off
fixed-rate payer = BBSW rate - Swap rate
floating-rate payer = Swap rate - BBSW rate
Company A wants to protect against interest rates rising on its variable (BBSW) borrowings of $500,000. Company A decides to fix the rate at 5.5% by entering into a fixed-for-floating interest rate swap with TYM Bank, with quarterly exchanges.
BBSW at the end of the June quarter is 5.75%
final cash flows for Company A
Company A interest owed on variable rate borrowings:
$500,000 x 0.0575 x (91/365) = 7,168
Swap payment received by Company A from TYM Bank (312)
Company A net interest on borrowings = 6,856
Effective interest rate = 6,856 / ($500,000*(91/365)) = 0.05500 = 5.5% = the fixed rate under the swap
Interest rate options
buying an option gives you a right
selling an option gives you an obligation
Caps
protect against rising interest rates
'capping' the interest rate (for borrowers)
buy an interest rate call option
the right to pay the cap (strike) rate at a future date
"long cap"
Floors
protect against falling interest rates
puts a 'floor' on the interest rate (for investors)
buy an interest rate put option
the right to receive the floor (strike) rate at a future date
"long put"
Which of the following would be the most likely reason for a company to enter into an interest rate collar option?
to cap the interest rate paid on borrowings at nil to minimal cost
to cap the interest rate paid on borrowings and make a profit on the option
to cap the interest rate paid on borrowings and benefit from any decrease in rate
Collars
used to decrease the cost of buying an option
buy a cap option to protect against rising rates
sell a floor option and receive a premium
right to pay the cap rate - pay premium
obligation to pay the floor rate - receive premium
E.g. protect against rising rates
sell a floor option (4%)
buy a cap option (6%)
BBSW = 4%
effective rate = floor 4%
BBSW < floor rate
effective rate = floor rate
BBSW = 7%
effective rate = cap 6%
BBSW > cap rate
effective rate = cap rate
BBSW = 5%
effective rate = BBSW = 5%
floor rate < BBSW < cap rate
effective rate = BBSW
Swaptions
an option to enter into a swap
payer swaption - pay fixed
receiver swaption - receive fixed
key points
if the swaption is "in the money", it will be exercised
e.g. for a payer swaption: if actual swap rate > swaption rate
ift he swaption is exercised then the swap will occur
otherwise, the swap does not occur
5. accounting and controls
reporting
governance
Accounting for interest rate risk products
derivatives must be recorded in the balance sheet at fair values (IFRS 9)
does the hedge qualify for hedge accounting?
e.g. eligible hedging instruments, eligible hedge items, formal designation, documentation and hedge effectiveness?
if yes, then fair value gains and losses can stay on the balance sheet until the underllying transaction is recorded in the P&L statement
Fair value
asset exchanged or liability settled
between knowledgeable, willing parties
arm's length, orderly transaction
present value of future cash flows
derivative fair values also incorporate counterparty credit risk
On 30th June 20X4, Wombat Pty Ltd entered into a fixed-for-floating interest rate swap on a notional principal of $1 million maturing on 30th June 20X9. Interest is calculated annually, with a fixed rate of 6% and a floating rate BBSW plus 1% margin.
You have been provided with the following market rate information as at 30 June 20X5 and requested to calculate the fair value of the swap.
Calculate the following amounts:
1. The discount factors that apply for each maturity date
= 1 / (1+4.5%)^(365/365) = 0.9569
= 1 / (1+4.75%)^2 = 0.9114
= 1 / (1+5.0%)^3 = 0.8638
= 1 / (1+5.5%)^4 = 0.8072
2. The 1-year forward rates that apply for each future period
= (DFnear / DFfar - 1) x (365 / d)
= ((0.9569/0.9114)-1) x (365/365) = 4.99%
= ((0.9114/0.8638)-1) x (365/365) = 5.51%
= ((0.8638/0.8072)-1) x (365/365) = 7.01%
3. The fair value of the swap
= PV of floating cash flows + PV of fixed cash flows
191120
Comments