Managing treasury risk: Interest rate risk (Part II)

|31-1-2017 | Lionel Pavey |

 

There are lots of discussions concerning risk, but let us start by trying to define what we mean by risk. In my first article of this series I wrote about risk managment and what the core criteria are for a solid risk management policy. Today I want to focus on interest rate risk. There are 4 types of interest rate risk.

 

Absolute Interest Rate Risk

Absolute interest rate risk occurs when we are exposed to directional changes in rates – either up or down. This is the main area of rate risk that gets monitored and analysed within a company as it is immediately visible and has a potential effect on profit.

Yield Curve Risk

Yield curve risk occurs from changes between short term rates and long term rates, together with changes in the spreads between the underlying periods. Under normal circumstances a yield curve would be upward sloping if viewed as a graph. The implication is that longer term rates are higher than short term rates because of the higher risk to the lender and less liquidity in the market for long dated transactions. Changes to the yield curve (steepening or flattening) can have an impact on decisions for investment and borrowings, leading to changes in profit.

Refunding or Reinvestment Risk

Refunding or reinvestment risk occurs when borrowings or investments mature at a time when interest rates are not favourable. Borrowings or investments are rolled over at rates that had not been forecast leading to a potential loss on projects or investments.

Embedded Options Risk

Embedded options are provisions in securities that cannot be traded separately from the security and grant rights to either the issuer or the holder that can introduce additional risk. Benefits for the issuer can include a call option, a right to repay before maturity without incurring a penalty, an interest rate cap. Benefits for the holder can include a put option, a conversion right via convertible bonds, an interest rate floor.

 

An attempt can be made to calculate the interest rate risk on either a complete portfolio or on individual borrowings or investment. This is done by comparing the stated interest rate to the actual or projected interest rate. Methods include:

  1. Mark to market
  2. Parallel shift in the whole yield curve
  3. Tailor-made shift in the whole yield curve
  4. Duration, DV01, Convexity
  5. Value at Risk (VaR)

These are all forms of quantitative analysis and well recognized. Personally I am of the opinion that VaR is not a very good method for interest rates. Interest rates do not display normal Gaussian distribution – they do not resemble a normal bell curve. Interest rate distribution curves display fat tails compared to normal statistical models.

Financial products that are commonly used to manage interest rate risk include FRAs, Futures, Caps, Floors, Collars, Options, Interest Rate Swaps and Swaptions.

Lionel Pavey

 

Lionel Pavey

Cash Management and Treasury Specialist

 

 

 

More articles from this author:

Safety of Payments

The treasurer and data

The impact of negative interest rates

How long can interest rates stay so low?

 

Managing interest rate and liquidity risk

| 06-09-2016 | Rob Söentken |

skyscrapertxl

 

Funding is one of the key focus areas of a treasurer. There are numerous dimensions to funding:
1. Assessing amount and timing of cashflows
2. Arranging access to funding
3. Developing and implementing hedging policy
4. Optimizing funding cost and risk

Assessing amount and timing of cashflows

Assessing the amount and timing of cashflows is a continuous process. Because needs can change both in short and long term.

Arranging access to funding

Matching funding needs with supply from financial institutions is also a continuous process. The typical approach would be to match tenors, but immediate access to cash is critical for the survival of any entity. It could be considered to arrange longer term financing, even for short term (revolving) funding needs. The downside is that long term access is more expensive than short term access. This may be acceptable, but if the spread between borrowing and lending excess cash is too wide, it will become very unattractive to borrow for long tenors.

Developing and implementing hedging policy

To ensure the treasurer works within the boundaries of his mandate, he has to develop a hedging policy which must be documented (‘on paper’) and approved by his management. The document should describe the whole area of funding, to ensure both the creation and hedging of risks are described.

Optimizing funding cost and risk

The main focus drifts towards reducing funding cost. The funding market typically has a steep cost curve, meaning that rates are higher for longer tenors. This results from a steep ‘risk free’ curve and / or from a steep ‘credit spread’ curve. Which often brings entities to borrow for the cheapest tenor possible, being monthly, weekly or even overnight funding. Funding for very short tenors creates the considerable risk that can cause a company to run into a liquidity crisis, in case access to funding disappears. How to deal with this dilemma?

The best approach is to define a number of scenarios to assess the impact of combinations of financing and hedging on funding and risk. A base scenario could be to finance all funding needs using overnight loans. In case of liquidity problems, what would be the impact on the funding rates? Another scenario would be using quarterly funding or yearly rollover funding, potentially combined with:

  • money market futures
  • interest rate swaps
  • caps / floors
  • bond futures or even
  • credit derivatives

What are the incremental funding cost? What are incremental operational expenses of running various products? Can the entity deal with managing margin requirements? Is the entity aware of the basis risks involved when using credit derivatives, which are fairly complex products?

Rob Soentken

 

 

Rob Söentken

Ex-derivatives trader

 

The impact of negative interest rates

01-08-2016 | Lionel Pavey |

rating

 

Articles in the press state that large commercial banks are considering charging their corporate clients negative interest rates on credit balances on their bank accounts. This presents us with certain problems – how will clients react?

Withdraw money – known as stuffing money under the mattress. This would present huge security issues on where the money could be safely kept, potential theft etc. Holding cash would give a return equal to zero, which would be greater than depositing it at a bank.

Hoarding – by withdrawing money from the banking system, banks themselves would have less money to lend and would force them to reduce their balance sheets. Conversely the idea would be that people would spend more money rather than save and, therefore, boost the economy. Would it work? We are seeing negative yields on high quality government bonds, for a variety of reasons, yet it appears that negative rates have not boosted spending or investment. The loosening of monetary policy does not appear to have removed market fears.

Disintermediation – banks fulfill a role as intermediar/middleman in the supply chain of finance. If money is withdrawn from the banking system it would be even harder for banks to provide finance to lenders. How could lenders then obtain the funding they require? Virtual marketplaces could be envisaged but there are so many security and safeguard issues that would need to be addressed before this could take place. Most companies can not borrow from capital markets – they rely on banks to provide their funding. Reductions in government bond yields to below zero do not lead to more funding being given to companies.

Worst case scenarios – companies will invest in technologies that are capital intensive leading, eventually, to a fall in the demand for labour. Pensioners who are dependent on interest income will be forced to reduce their consumption leading to a fall in demand. With safe yields being negative the search for yield could lead investors into riskier assets than they would normally consider.

A stamp on physical cash – this is an idea more than 100 years old proposed by Gesell to stop hoarding of cash. Bank notes would need to receive a stamp every month to be considered valid cash. These stamps would have to be purchased (a form of negative interest) and their purpose would be to erode the principle that money is a store of value and could be better used by being actively invested in the economy.

This all sounds very pessimistic, but there are potential gains from negative interest rates for companies.

It would encourage companies to pay their creditors more quickly and, in the process, receive discounts on their purchases outstanding if they pay early. Furthermore it would enable companies to truly examine their whole supply chain across all departments within a company and create a better understanding of the workflow processes concerning cash receipts and disbursements.

For those who like a more rogue approach, you could actually overpay your creditors and ask for a credit note. Now your creditor is funding your negative interest rate and if true economic theory principles are maintained – a fall in prices should follow negative interest rates – then, not only you would have handed over your negative interest rate exposure but you would also benefit from falling prices in the future on the outstanding credit notes with your creditors allowing you to make a relative saving on the future purchase price.

It is clear that steering interest rates will not sort out the economy – other steps outside of monetary policy will have to be taken to restore faith in the economy. But which steps will that be?

 

Lionel Pavey

 

 

Lionel Pavey

Cash Management and Treasury Specialist

 

Zero Coupon Yields and implied Forward Yields

| 13-06-2016 | Lionel Pavey |

 

Having constructed our 20 year yield curve with both observable data and discovered data in my previous article,we are now in possession of 3 sets of data:

  1. Spot par rates
  2. Spot zero coupon rates
  3. Discounted Cash Flow factors (DCF)

The most important of these, for calculation purposes, is DCF.

Present Value

The discounted present value of a future cash flow can be calculated by dividing the future value by the DCF. It therefore follows that a series of future cash flows can also be discounted to a single net present value.

Implied Forward Rates

The original yield curve showed annual spot rates for a period of 20 years. Using DCF it is possible to construct similar curves but with forward start dates – a curve starting in 1 year, 2 years, 3 years etc. When building these curves the “implied” forward rate will actually be a zero coupon rate and not a par rate. Converting the zero rates to par rates can be achieved by using Excel Solver – a very useful tool but great care must be taken as Solver gives an answer but shows no formula.

So, how do we calculate an implied forward rate?

Let us assume that we wished to find a rate with a duration of 4 years, starting 5 years forward.
To achieve that, we need both the 5 year DCF and the 9 year DCF

The previous constructed curve yields the following values –

5Y DCF                    =               0.9464924176

9Y DCF                    =               0.8508986778

((.9464924176/.8508986778)^(1/4)-1)*100     =  2.6975% implied 4 year rate starting in 5 years

As stated, this is the implied zero coupon rate – the implied par rate is 2.6887%

All forward rates are purely implied rates – a true quoted rate would always be different for various reasons –

  1. Spread between bid and offer
  2. Yield curve constructed with specific data
  3. Sentiment of the trader
  4. Possible exposure already in the banks’ books

Here is a small snapshot of both implied rates and par rates built with the original curve.

parrates complied rates

When I discussed building the original yield curve, different ways of interpolation were tried. I would now like to show how small differences in yields in a spot curve can lead to significant differences in a forward curve.

Let us look at a duration of 5 years starting 10 years in the future and compare the linear interpolation with the smooth adjusted curve. Assume that the instrument to be priced is a linear instrument – equal repayments of principal every year.

I have built both curves using the same layout and formulae throughout with the exception of the input rates in the missing periods.

The linear rate is 3.276%; the smooth adjusted rate is 3.416% – a difference of 14 basis points or about 4% of the smooth rate. In a market where the normal bid/offer spread is about 3 or 4 basis point, this represents a significant difference/anomaly.

I regularly hear people say that when they need to purchase a financial instrument that they get at least 2 quotes – this is all very well but does not stop a treasurer from first ascertaining what the correct price should be before getting a quote. If banks know that, as a treasurer, you can not calculate the theoretical price this allows them to move the price away from the implied to a price that is more advantageous to them and their trading book! A dedicated financial data vendor system can make life easier, but it is not impossible to calculate a price without these resources!

 

Next – Spreads; their use and the hidden extra costs

First two articles on building a yield curve:
1. Yield Curves (term structure of interest rates) – filling in the blanks
2. Yield Curves (term structure of interest rates) – filling in the blanks part II

 

Lionel Pavey

 

 

Lionel Pavey

Treasurer

 

 

Yield Curves (term structure of interest rates) – filling in the blanks part II

| 03-06-2016 | Lionel Pavey |

Most treasurers do not have access to a dedicated financial data vendor (Bloomberg, Reuters) but are regularly faced with having to discover prices related to yield curves. There are websites that can provide us with relevant data, but these are normally a snapshot and not comprehensive – the data series is incomplete. It is therefore up to the treasurer to complete the series by filling in the blanks. In my previous article I went over the first approach. Today I’ll talk about the second approach.

A second approach would be to apply a weighting to the known periods of the par curve and to average the difference out over the missing periods.

grafiek1_part2

Schermafbeelding 2016-06-02 om 13.49.46

This leads to 1 year constant maturity rates that are almost equal in value for all the periods between 2 known periods. Whilst these forward rates are also not correct they at least supply us with a visual indicator as to the general shape of the forward yield curve – the 1 year constant maturity rates

reach their zenith between years 12 and 14; after that point they then start to decrease.

Futhermore, taking into consideration the yield curve as shown in the graph, we can make the following conclusions about the 1 year curve:-

  • 11 year rate must be higher than the linear interpolated rate but lower than the weighted interpolated rate
  • 13 year rate must be higher than the weighted interpolated rate
  • 15 year rate must be lower than the linear interpolated rate and lower than the weighted interpolated rate
  • 16 year rate must be higher than the linear interpolated rate and higher than the weighted interpolated rate
  • 20 year rate must be lower than the linear interpolated rate and lower than the weighted interpolated rate
  • The implied forward 1 year constant maturity curve must be smooth and monotonic.

On the basis of these restraints a par curve can be built that leads to the following forward curve.

grafiek2_part2Schermafbeelding 2016-06-02 om 13.50.01

The rates for the missing periods have been calculated manually whilst adhering to the conditions mentioned before– there are formulae which would allow rates to be discovered (Cubic spline, Nelson Siegel etc.) – but these rely on random variables and I have yet to see anyone quote and trade prices based solely on a mathematical formulae.

Visually, the 1 year curve meets all the criteria for the construction of a yield curve, together with the underlying par and zero yield curves.

grafiek3_part2

 

To ascertain that the rates are correct, discount all the cash flows of the par yield for the given maturity – they should equal 100.

Here is an overview of all the implied 1 year rates using the different methods to construct the yield curve.

Conclusion:

For a quick calculation a straight line interpolation is acceptable with the warning that with a normal positive yield curve the real prices will be higher than the prices calculated by straight line interpolation. For a negative yield curve this would be reversed – real prices lower than interpolated prices.

The average difference between the par yield prices of the adjusted smooth yield and the straight interpolation yield are only 2.5 basis points. However, this difference is magnified when looking at a 1 year forward yield curve where the average difference is 22.5 basis points per period with a maximum of 53.5 basis points.

Next – Zero Coupon Yields and implied Forward Yields

Would you like to read part one of this article?
– Yield Curves (term structure of interest rates) – filling in the blanks

 

Lionel Pavey

 

 

Lionel Pavey

Treasurer

 

Yield Curves (term structure of interest rates) – filling in the blanks

| 27-05-2016 | Lionel Pavey

Most treasurers do not have access to a dedicated financial data vendor (Bloomberg, Reuters) but are regularly faced with having to discover prices related to yield curves. There are websites that can provide us with relevant data, but these are normally a snapshot and not comprehensive – the data series is incomplete. It is therefore up to the treasurer to complete the series by filling in the blanks.

A quick refresher about the construction of a yield curve raises the following points:-

  • All data must be from the same market (treasury bonds, Interest Rate Swaps (IRS) etc.)
  • A regular term (maturity) is preferred for ease of construction
  • A curve must be smooth
  • An implied zero yield curve can be built from the smooth par curve – a theoretical yield curve where no interest is paid until maturity. In a bond this would redeem at par (100) and be issued at a deep discount to par
  • A series of discounted cash flow factors (DCF) are produced
  • An implied forward curve with constant maturities can be built from the par curve
  • An implied forward curve must be monotonic – each point in an increasing sequence is greater than or equal to the preceding point, each point in a decreasing sequence is smaller than or equal to the preceding point

If we look at IRS par yield prices that can be found on a website, we can regularly see yield prices for periods from 1 year to 10 year inclusive, a 15 year price and a 20 year price. To construct a complete curve from 1 year up to and including 20 years we need to fill in the blanks at 11,12,13,14,16,17,18 and 19 years. These yields are assumed to be par yields – the coupon rate is equal to the yield to maturity and the instrument trades at par.

Before starting let us define the procedure for constructing a par yield curve:-
The methodology used is called “bootstrapping”. This allows us to extract discount factors (DCF) from the market rates. DCF’s allow us to calculate a value today for a cash flow in the future.

We assume that the nominal value for all calculation purposes is 100

For a 1 year rate we know the interest and redemption amount at maturity. A DCF is built whereby the net present value (NPV) of these future cash flows in 1 years’ time is equal to 100 or par.

For a 2 year rate we receive interest after 1 year and interest and redemption amount at maturity.

We discount the 1st years’ interest with the DCF we obtained from the 1 year rate and deduct this amount from our initial nominal of 100. This net amount is then divided by the interest and redemption at maturity (at end of 2 years) to obtain the DCF for the 2 year rate.

Example:

1 Year                                      7%                          2 Year                          9%

1 Year      
100 / (7/100+100) = 0.93457944 (DCF)

2 Year
9 * 0.93457944 = 8.41121496
100 – 8.41121496 = 91.58878504
91.58878504 / (9/100+100) = 0.8402640829

These DCF’s can then be used to find the NPV of any cash flow maturing in 1 or 2 years’ time.

The following example shows a yield curve from February 2013 published on the website of an interbank broker.

yield curve February 2013

yield curve February 2013

The quickest way to price the missing periods would be with straight line interpolation of the par curve between the known points – which would produce the following par curve, zero yield curve and forward curve with constant 1 year maturity.

yield curve February 2013 - 2

yield curve February 2013

Straight line interpolation

Straight line interpolation

 

Whilst the par curve and zero curve are smooth, the implied 1 year constant maturity curve is jagged and certainly neither smooth nor monotonic. The 11th 1 year period rate is lower than the 10th period and the 15th 1 year period rate is higher than the 16th period.

A second approach would be to apply a weighting to the known periods of the par curve and to average the difference out over the missing periods. Read more on this second approach in my next article which will appear next week.

Lionel Pavey

 

 

Lionel Pavey

Treasurer

 

 

Short note on interest rate derivatives

16-05-2016 | by Ad van der Plas |

 

They are often in the news, but what are they and how do they work? Interest rate derivatives are derivatives of the money- and capital markets and are especially designed to give assurance on the interest rate you will have to pay or receive in the future. Best known is the interest rate swap, a swap between the fixed and variable interest rate. All other interest derivatives are calculated on the interest rate swap. How does this swap work?

The interest rate swap is a two party agreement, usually in ISDA model, in which the fixed and variable interest amounts are swapped. The swap period, the fixed and variable (reference) interest rate are defined. The interest is calculated on the agreed notional principal amount and the interest amounts are payable on the payment dates. One party receives the fixed rate amounts and pays the variable rate, and the other party receives the variable rate amounts and pays the fixed rate.

With buying an interest rate swap, you can change the interest rate risk of an underlying loan from an uncertain variable rate to a certain fixed rate. That is….if during the swap period there are no changes in the loan itself. Since you aim to obtain certainty you should be aware of potential uncertainties during the swap period, such as:

  1. A change of the reference rate in terms of content or effective representation (Libor).
  2. A change in the interest rate calculation of the loan caused by regulatory changes in the financial markets (Solvency) or due to balance sheet effects of the lending company itself like a liquidity surcharge.
  3. The lender changes the surcharge because he has revised the credit rate of your company.
  4. The underlying loan is canceled or restructured.
  5. The counterparty in the swap agreement requires an additional payment if the swap has a negative value.
  6. Possible P&L and Balance sheet effects due to changes in the valuation of the swap because of changes in regulations, for example IFRS.
  7. A different interpretation of the regulations when changing your auditor.

Please also note that the outstanding swap agreements will have effect on your total financing capacity. And finally, a warning: improper use of derivatives can be a big risk. Be sure to have a professional opinion when using derivates.

Ad van der Plas

 

 

Ad van der Plas

Independent Treasury Consultant & Interim Manager

Negative Interest Rate Policy: No lasting effect on FX

14-04-2016 | by Simon Knappstein |

bank

 

Negative interest rates are gripping Central Banks worldwide. The BoJ has resorted to this unexpected and unusual policy at the end of January. The ECB is expected to dig deeper into negative realms at their March meeting. The Swedish Riksbank has also gone negative and the Fed is contemplating the possibility for the eventuality economic growth will falter and inflation will fall. And of course the Swiss are already quite accustomed to negative interest rates. But in the FX markets the effects are minimal and short-lived.

So, are Central banks reaching the end of the effectiveness of their extremely loose monetary policies? If so, the big question is what next? Plain currency intervention? Hard to imagine currently, though the Swiss National Bank is said to be continuously intervening to prop up EUR/CHF.

The ECB has crossed the zero interest rate border in the summer of 2014 bringing its depo-rate to minus 0.10%. A move intended to stimulate credit growth by commercial banks, and as a means to lower the value of the Euro as to import more inflation. Although the latter was not explicitly mentioned everyone knows it was.

Since then the Swiss National Bank in December 2014, the Riksbank in February 2015 and the Bank of Japan in January 2016 have followed suit by introducing negative interest rates.

Currency impact

Interest rates
Figure 1 – Currency impact

The impact on the currency exchange rate is questionable and certainly not a straightforward main driver, as can be seen in figure 1.
When the ECB introduced a negative interest rate in the summer of 2014 it was accompanied by the start of the QE program and indeed EUR/USD moved considerably lower. The rate cut to -0.3% last December had no material impact on the exchange rate, even though it was followed by the first Fed rate hike in years.

The pressure on EUR/CHF could not be relieved by a rate cut to -0.25% in December 2014 so it was soon followed by the abandoning of the minimum exchange rate at 1.20 and a further cut to -0.75%. EUR/CHF stabilized but only continuous intervention by the SNB has brought the pair higher since then. The charts for EUR/SEK and USD/JPY speak for itself.

The conclusion is that there is very little to no evidence that negative interest rates lead to weaker currencies to support inflationary pressures.

Simon Knappstein - editor treasuryXL

 

 

Simon Knappstein

Owner of FX Prospect