The markets are in a state of flux

2022 was an eventful year in many respects. From a treasurer's perspective, there are two developments that stand out: For one, political instability – among other drivers – pushed commodity risk back into the treasury spotlight at many companies. Second, the decade-long era of low and negative interest rates has drawn to a close. Many will still remember the initial challenges that came with the onset of this era. Among them, for example, were the discussions about negative interest rates versus custody fees or treasury systems that had yet to improve their functionality to reflect negative interest rates. There was a shift in focus from maximizing interest income to avoiding interest costs when investing funds – but in return, financing was very favorable and some companies actually succeeded in generating income from negative interest rates. Most treasury departments were quick to adapt to the low interest rate phase.

However, owing to just how long and stable the low-interest phase was, treasury departments lost sight of the issue of interest rate risk to a certain extent. But the markets have shifted, and the time has come to scrutinize and, to a certain extent, dust off in-house processes and methods in interest rate risk management.

Looking at interest rate risk from different angles

Unlike (exchange) rate risk, interest rate risk cannot easily be captured in a single risk metric. Instead, it should be approached from a number of different perspectives. In corporate treasury practice, the dominant perspective is often the cash flow view, in which variable interest payments represent a risk as a potential deviation from the plan or as a potential loss of liquidity. In this respect, variable-interest investments and financing offer the advantage that they have a more stable market value in the event of interest rate changes and do not include a premium for a long-term fixed interest rate. The second common view used in companies, at least for financial assets, is that of market value. In this present-value view, fixed-interest items are considered to be higher risk.

Another perspective that comes into play at this stage is the accounting view: For instance, if issued bonds are accounted for at amortized cost, the change in market value of a fixed-income bond in the event of interest rate fluctuation does not show up immediately at all, but is realized over the entire term. This may sound like an advantage at first and is one reason why companies focus on variable interest rates as a risk driver. 

However, such an approach can lead to a misguided strategy. As an example, let's look at a company that issued long-term fixed-interest bonds shortly before the reversal of interest rates. In the balance sheet view, this forward-looking fixed interest rate initially goes unrewarded, as the acquisition costs remain unchanged - the benefit only becomes properly visible in the present-value, fair-value view. At this point, one distinctive feature of the balance sheet view and the cash flow view becomes clear, namely their periodic view: To obtain an accurate picture, not only the current period but also all future periods would have to be considered in order to make the long-term fixed, low interest rates of the issued bond visible.

As such, each of the different perspectives has its own merits and its own "blind spots." In the context of interest rate risk management, the different perspectives should therefore be considered in parallel. This requires the definition of suitable key figures for each of these perspectives, which only in their entirety can provide a complete picture of the interest rate risk. 

Scenarios are the key to risk measurement

When assessing interest rate risk, yet another challenge is the ability to model the change in interest rates appropriately. By their very nature, simple risk models that estimate future changes from a time-limited history (for example, using an EWMA approach based on price changes over the past few months) hit their limits here, as the erratic pattern of changes in interest rates can only to a very limited extent be extrapolated from short-term history. Not unlike our intuition, during a period of stability they quickly get used to the status quo and then underestimate the risk of a jump in interest rates. Also, it is difficult to integrate leading indicators such as central bank announcements or news about policy changes into time series-based approaches.

One way around this is to analyze dedicated change scenarios. This allows good interest rate risk measurement with moderate effort. Many companies already use scenario analyses, but they frequently limit themselves to very simple variants such as a uniform interest rate change of 100 basis points across all maturities. However, scenario analysis actually offers much deeper insights. If appropriately defined, such scenarios can identify cash flow and market changes that correspond to cash flow-at-risk or value-at-risk measures of the desired confidence level and significantly exceed those of simple risk models in terms of quality. In addition, it allows existing experience from the banking sector to be incorporated, where detailed scenario analysis is part of the tools of the trade in interest rate risk management and is part of the regulatory requirements.

Planning is a must

Once the risk measurement issues have been clarified by defining appropriate scenarios and metrics for the various perspectives, it would seem at first glance that all the building blocks for analyzing one's own position are in place. And indeed, a present value consideration can be accomplished by applying scenario analysis to the current position. However, in a periodic view, as is required in the balance sheet or cash flow view, the actual positions gradually expire and this gives a misleading picture.

For an accurate presentation, therefore, the expiring items must be updated in an appropriate manner. In a first step, expiring transactions are simply replaced by transactions of the same type (i.e. with the same maturity and the same type of financial instrument). But in order to obtain a realistic picture, it is also necessary to take future liquidity developments into account. At this point, linking interest rate risk management with the existing planning processes in the company is the obvious solution, as these usually already contain the required information and allow for deriving the necessary extrapolation logic by simple means.

Risk identification with the interest rate gap analysis

When determining the interest rate risk, another aspect is the definition of the components to be included in the analysis. This typically involves concentrating on financial items, i.e. financing and cash investments. At this point, it is advisable to prepare an interest rate development report. This involves grouping the assets and liabilities of the existing position together with the planned updates in terms of their fixed-interest period. Based on these figures, it becomes clear for which maturities there is an interest rate risk.

Compiling a complete picture including the non-financial positions requires a more complex analysis, but enables an overall view of the interest rate risk that also takes into account balancing effects between financial and operating positions. The non-financial items are included in the interest rate development report with suitable assumptions (for example, about planned operating lives or depreciation).

This interest rate development report serves as an intermediate step in establishing the key figures in the various perspectives or as a supplementary visual representation of the exposure in cases where it is possible to calculate the key figures directly using suitable systems.

Tackling active management

Along with the methodology for measuring risk, the main challenge for many companies is how to determine the right positioning in the interest rate space, for example, choosing the right ratio of variable-rate to fixed-rate financing.

Finding the right interest rate strategy must be based on a company's specific characteristics and requirements. Three fundamental aspects in this regard are: 

Individual profile: A company's own corporate and business characteristics, for instance dependency on business cycles, cash flow stability or leverage, will all have an impact on which strategy is most beneficial for a company or if it is even possible at all.

Background: For narrowing down a solution scope for optimal positioning, the relevant dimensions (for example, permitted currency areas, suitable financial instruments, permitted nominal values) and the corresponding restrictions must be prepared. 

Objectives: Ultimately, key figures resulting from the various requirements for interest rate risk management, such as maximizing interest income and minimizing cash flow risk, are used to evaluate a positioning.

Starting from an analysis of these aspects, an overall approach can then be derived to determine the correct interest rate position.

Source: KPMG Corporate Treasury News, Edition 137, October 2023
Nils Bothe, Partner, Finance and Treasury Management, Corporate Treasury Advisory, KPMG AG
Dirk Bondzio, Senior Manager, Finance and Treasury Management, Corporate Treasury Advisory, KPMG AG