In this chapter, we introduce several important qualitative aspects of an interest rate risk management policy. There are a large number of choices to be made in defining such a policy, and most companies formalise them in a risk management policy document. This document should provide a balance between operational freedom and company oversight and control. To achieve this, it has to specify the risk management parameters in sufficient detail that it protects the company against unauthorised use of derivatives while not paralysing the Treasury department, which has to implement the policy often quickly and in volatile market conditions. The main areas of any risk management policy document are:

- the risks that should be hedged and how;
- roles and responsibilities for various risk management functions (who does what);
- authorised derivative instruments;
- limits on the use of derivatives; and
- reporting requirements and when to deviate from the policy.

BACKGROUND

A European media company, Media Corporation, is seeking to grow through acquisition. The company’s policy has historically been to grow organically, but management has now decided to pursue a more aggressive expansion policy. The change in policy will lead the company to issue more debt.

The treasury department of Media Corporation is faced with an increased exposure to interest rate risk, and therefore plans to put in place a state-of-the-art interest rate risk management framework. Media Corporation needs our help in the development of their interest rate risk management policy.

COMPANY OBJECTIVES

- To put in place an interest rate risk management policy.
- To evaluate the risks from the use of derivatives and ways of mitigation.

ANALYSIS

We arrive at bespoke recommendations for Media Corporation through a synthesis of sector-specific risk management practices and general principles of prudent risk management (“best practice”), applied to the specific circumstances of Media Corporation. Since the risk management policy consists of many linked parts, we shall group them according to the scheme in Figure 9.1.

STEP 1: FROM SCOPE TO PORTFOLIO CONSTRUCTION

Scope of risk management policy

When defining the scope of an interest rate risk management policy, companies have a choice on how far forward to look in terms of expected debt and cash position. This choice is similar to the choice on the currency side between hedging only the contractual foreign cashflows or also the forecast ones. In fact, the two choices (on the FX and interest rate sides) are clearly linked, since forecast foreign cashflows impact the forecast amount of debt and cash. The major difference is that contractual liabilities on the interest rate side are normally of much longer duration than on the currency side. For instance, a company that has issued a 10-year fixed coupon bond can decide to swap it to floating much more easily since the bond is likely to stay in place for the next 10 years. Very few companies have the same level of certainty about their foreign currency cashflows.

Most companies define the scope of interest rate policy as their current exposures, and some also look to prehedging future debt issuance (the topic of prehedging future debt issuance will be discussed in Chapter 13).

Risk management approaches

We see three types of approach to risk management.

- Conservative approach (about 30% of companies): This is characterised by a low level of risk appetite. The main aim is to avoid possible losses due to market fluctuation through a total hedging of the exposure,¹¹ For a typical company, hedging of the interest rate exposure means fixing the rate to be paid on the company’s debt. while minimising the cost of such operations. The potential benefit from favourable market movements is not targeted. Another objective is to minimise the accounting variability as much as possible, and therefore all hedges should aim to qualify for hedge accounting under IFRS as far as it is possible. The instruments used offer only a linear payout – ie, an interest rate swap. This approach was most common when IFRS was first put in place in 2005, but is being increasingly replaced with the dynamic approach by many companies.
- Opportunistic approach (about 10% of companies): This is characterised by a material level of risk appetite. The aim is to outperform market levels by actively managing positions. The treasury’s objective is to generate shareholder value through active risk management. Limitation of the accounting variability is not an absolute requirement, and therefore positions entered into do not have to qualify for hedge accounting under IFRS. The instruments used can include leveraged structured strategies, such as range accruals.²² Range accruals are derivatives whereby the company pays a lower coupon while a certain index, such as Libor or EURUSD, is within a given range. This approach has rarely been adopted by corporations, especially since the introduction of IFRS.
- Dynamic approach (about 60% of companies): This is a compromise between the conservative and opportunistic approaches, and involves an intermediate level of risk appetite. The objective is not to exclusively minimise the impact of unfavourable market movements, but also to benefit from positive variable changes while minimising the overall risk and the cost of such strategies. This approach requires dynamic management focused on constant market trend monitoring, which allows the capture of market opportunities by partial repositioning of a hedging portfolio. Instruments used include swaptions, collars or FX options. Most instruments satisfy hedge accounting, with a small and controlled proportion being kept in an MTM portfolio.

Before defining the risk management approach, our starting point is to define the primary objectives of risk management for Media Corporation as:

- reducing economic variability through hedging strategies to defend the corporate business plan – ie, reducing the impact of market movements on the economic model and key financial variables, financial ratios, financial targets (both internal and external) and covenants;
- minimising the costs of the hedging strategies, as long as this does not endanger the first objective; and
- reducing the accounting variability introduced by the hedging programme according to the accounting standards, as long as this does not endanger our first two objectives.

Risk management must obviously be based on best industry practices and prudent management of the compromise between downside risks, the potential for upside rewards (eg, the possibility to participate in favourable market movements) and the expected payout on the overall portfolio basis. These objectives imply that Media Corporation should adopt the dynamic approach.

Now that we have defined the objectives and the risk management approach of Media Corporation, the next step is to create the hedging portfolio with a composition that would best satisfy the objectives. Before we do that, however, we should clarify what we mean by a hedged or not hedged portfolio when it comes to interest rate risk management. A typical company has debt that is fixed or floating in a number of currencies. It also has cash and short-term deposits in different currencies, which are normally floating. For the purpose of our discussion, let us defer the discussion of currency mix to Part III and assume that the scope of the interest rate risk management policy can be simply split into three elements, all in the same currency:

- fixed debt (eg, bonds of various maturities);
- floating debt, with coupons linked to Libor or Euribor (eg, loans or floating rate notes, FRNs, of various maturities);
- cash and short-term deposits, which are all floating – here we consider only the core cash that is likely to stay on the balance sheet for a sufficiently long time to match the floating rate debt, and ignore the day-to-day or seasonal variations in cash.

As mentioned in the introduction to this part of the book, companies normally care less about the fair value (ie, MTM risk) of their liabilities since they plan to keep them until maturity. The real risk is the risk to cashflows – ie, interest cost. Part of the risk on the floating debt can be offset by the risk on cash,³³ For simplicity, whenever we refer to “cash”, we also mean short-term deposits. Whenever we refer to ‘floating debt, we mean the drawn part of floating rate loans and any FRNs. since they are in opposite directions: when the Libor rates go up, the cost of floating debt goes up, but so does the return on cash. We can see the two situations in Figure 9.2: (a) cash is lower than floating debt and (b) cash is higher than floating rate debt.

What we mean by “risky” is the floating part of the balance sheet, which is exposed to interest rates. In case (a), this is the amount of floating debt in excess of the cash. In case (b), this is the amount of cash in excess of the floating debt. In the first case, the risky part can be hedged by swapping the excess amount of floating debt to fixed, and in the second case by swapping the excess amount of fixed debt to floating (which is economically equivalent to swapping the excess amount of cash to fixed but could be easier to do from the hedge-accounting perspective).

Now what can we do to reduce the volatility of the risky portfolio? After hedging, the portfolio can be divided into three parts: hedge accounting; non-hedge accounting; and not hedged, whose accounting treatment is shown in Table 9.1.

Therefore, the conclusion is that, by default, companies should target a large part of the interest rate portfolio to be hedged by products that obtain a hedge accounting treatment. Only when a company has specific economic goals that cannot be satisfied with the hedge accounting products, should it consider non-hedge accounting products. An example of that is the forecast future floating rate loan that the company would like to fix prior to issuance via an interest rate swap, but the accountants will not give this a hedge accounting treatment as it cannot be demonstrated that the issuance is highly probable. In that case, the company may decide to hedge anyway, with the knowledge that the MTM of the swap would go through P&L. As part of its risk management policy, the company may impose a requirement that the size of the dynamic hedging portfolio is limited due to the extra accounting volatility. We give an example of this later in the chapter.

Finally, when should the company have a not hedged (aka “floating”) portfolio? It may decide that the amount of risk from the floating portfolio does not warrant any hedging. Alternatively, the company may decide, based on historical analysis, that the floating rate debt is generally cheaper than fixed, so they decide not to hedge a portion of the floating rate debt (this will be discussed in more detail in Chapter 10).

Optimal fixed-floating mix

When defining the fixed-floating mix, it is necessary to define precisely the part of the overall debt to which the required proportion applies. In the case of Media Corporation, this includes bank debt, bond issues and financial leases minus the core surplus projected cash.

Table 9.1 Composition of the interest rate portfolio after hedging

Part of portfolio	Description	Accounting treatment	Guidance on use
Hedge accounting portfolio (fixed, capped or collared)	Derivatives that qualify for hedge accounting in accordance with IFRS. These positions allow Media Corporation to reduce the economic variability of its financial results due to market movements without increasing the accounting variability. In some circumstances, IFRS allows for offsetting the variability of the hedging instrument against the variability of the underlying (“hedge accounting”), thereby reducing the accounting variability. This is the case only in those conditions when the exposure being hedged can be clearly identified and the hedging instruments are very simple. The objective of risk management is to maximise the hedge accounting portfolio. However, this policy recognises that it is not always possible to reconcile the economic hedging requirements with the hedge accounting ones. In those cases, economic requirements take precedence and positions are taken that do not satisfy hedge accounting.	Income statement is not impacted by market volatility, except for the ineffective part of the hedges.	Target a large proportion of the portfolio.
Non-hedge accounting portfolio	Derivatives that do not qualify for hedge accounting in accordance with IFRS. Therefore, the impact of fair value changes in the value of derivatives is recognised in the income statement. These positions encompass a wider variety of hedging strategies and deliver a higher level of flexibility in managing risks. Risk exposure is minimised by a prudent choice of instruments in the portfolio. These positions are only entered into when the economic goals cannot be achieved through the hedge accounting instruments.	Income statement is affected by market volatility.	Use only when it is not possible to achieve the same economic goals with the hedge accounting portfolio.
Not hedged portfolio (floating)	Part of the portfolio that is exposed to market volatility. Normally, positions are left unhedged only when required by market illiquidity, prohibitively high cost of hedging or specific market considerations (ie, if the company has a strong view that the forward curve is too steep).	Income statement is affected by market volatility.	Use when required by illiquidity, prohibitively a high hedging cost or specific market considerations.

Determination of the optimal fixed-floating mix is complex, and will be covered in the next chapter. In general, this is to be determined separately for each of the main debt currencies based on the following two considerations:

expected benefits in terms of interest rate saving realised by swapping from fixed to floating or by changing duration from long-dated fixed to short-dated fixed;
additional amount of interest rate risk from such an operation (including the impact of netting debt against the cash positions).

In determining the benefits and risk, treasury should take into account market variables, ie, current and forecast short and long interest rates and their volatility, and how these compare to history. Additional factors to be considered are the leverage and its future projections, and the current amount of interest rate risk measured through CFaR. All of these elements will be discussed in the next chapter.

After detailed analysis along these lines, Media Corporation decided to go for a 35% floating and 65% fixed debt mix. Expected future deleveraging (due to high EBITDA growth and a more conservative financial policy) may require the Media Corporation to reduce the fixed proportion.

Peer group analysis

Peer group analysis can play a role in this process, because most large European and North American companies report their fixed-floating mix in annual reports. However, naïve comparison of the fixed proportion of debt across different companies is difficult as we are not comparing like for like. The fixed-floating mix is an oversimplification of the company position for several reasons:

- it ignores duration (a one-year fixed coupon bond is not the same as a 30-year fixed coupon bond);
- it ignores currency composition (how much you should fix depends on the currency); and
- it ignores other derivative strategies (caps, collars, etc).

Our conclusion is that peer comparison should be used only as a very rough indication, and the optimal fixed-floating mix should be reached through other means. Moreover, there is a wide spread of fixed-floating mix choices among the peers, as there are other aspects that impact it. For instance, all of these reasons would imply a higher fixed proportion:

- the company’s perceived financial risk (higher than usual);
- interest rates and shape of yield curve (flat and low yield curve);
- the company’s rate expectations (interest rate rise expected); and
- cyclicality of companies earnings (less cyclical industries).

In any case, determining the optimal fixed-floating mix is just a first step towards defining the optimal liability structure (see Figure 9.3). For more details, see other chapters in Part II.

Use of options

As we said in Chapter 1, most of the corporate interest rate hedging is done with linear payout instruments – ie, interest rate swaps. Some companies add a few optional instruments to their risk management arsenal, namely interest rate caps, floors, collars and swaptions. The benefits of these instruments will be discussed in Chapter 11.

Whereas the treasury team often understands the additional benefits of using interest rate options, they may face obstacles in persuading their management that the use of options is not more speculative than the use of swaps, and that the additional risks related to options are justified by the benefits they offer. In our opinion, simple options (interest rate caps, floors, collars and swaptions) have their place in the toolkit of a sophisticated risk management team and should be explicitly permitted in the risk management policy. Similar to any other kind of hedges, their use should be very carefully thought out and scrutinised for potential risks.

STEP 2: ORGANISATIONAL ISSUES

Processes and organisation

Two important aspects of a risk management policy are the processes to be followed and the organisation that supports these processes. The Handbook follows a structured approach to risk management, and such an approach can also be implemented in risk management processes, from the establishment of the risk management policy to its implementation, monitoring and periodic review. While the basic principles are the same, the details change from one company to the next. In Figure 9.4, we show the organisation of the risk management function at Media Corporation, and the roles and responsibilities each participant undertakes.

Normally, such a detailed organisational scheme would predate the creation of the risk management policy. Somewhere in the policy, reference is made to other teams and their responsibilities in the risk management process.

Performance measures

The company will periodically assess and report the results of the interest rate risk hedging programme:

- the net exposure to market risk and percentage of hedging by portfolio type;
- the net cashflows;
- evolution of interest risk exposure according to budget and business plan scenarios;
- assessment of the effectiveness of the risk management strategy against the benchmark rates;
- accounting volatility introduced by the non-hedge accounting portfolio;
- sensitivity analysis of the market movements;
- compliance with the covenants of the financial model and/or any internal financial targets;
- the gross and net hedging costs of interest rate risk exposure.

Benchmarking

Companies define the benchmark interest rate in many ways:

- forecast rate – from a number of institutions, a consensus rate or some other combination;
- forward rate – the implied future rate from the swap curve;
- blended rate – a combination of a short-term rate (the Euro Interbank Offered Rate, Euribor, or the Euro Overnight Index Average, Eonia) and the long-term (swap) rate weighted according to the target fixed-floating mix; and
- an external benchmark – comparison against an external benchmark (eg, peer group).

Each approach has its downsides. Forecast rates are notoriously unreliable, while forward rates tend to overestimate the evolution of short-term rates, which makes the blended rate unreliable. In any case, when benchmarking a company’s risk management strategy against alternatives it is important to do so in a risk-adjusted way – ie, how well Media Corporation could do with another strategy that has the same amount of risk. There is no point in comparing the rate against a better rate that can only be realised with a more aggressive risk management strategy.

STEP 3: DERIVATIVES RISKS AND ACCOUNTING TREATMENT

Derivatives risks

The purpose of the use of derivatives is management of market risk; however, the use of derivatives exposes Media Corporation to the following additional risks.

- Valuation risk: The risk of changes in the level of derivative prices due to changes in interest rates, FX rates, commodity prices or other factors that relate to market volatility of the underlying rate.
- Liquidity risk: Changes in the ability to sell or novate⁴⁴ Novation is a process by which a company A exits a derivative position with a bank B by finding another counterparty, normally a bank C, which will take A’s position with B. For novation to happen, a payment may be needed between A, B and C. the derivative. Derivatives bear the additional risk that a lack of market liquidity or willing counterparties may make it difficult to close out the derivative or enter into an offsetting contract.
- Counterparty risk: The risk that a counterparty will not settle an obligation for full value when due. This is further discussed in Part IV of this book, and has significant implications for the interest rate policy since the interest rate derivatives are often long-dated.
- Settlement risk: The risk that one side of a transaction will be settled without value being received from the counterparty. Settlement failures can arise from counterparty default, operational problems, market liquidity constraints and other factors. Settlement risk is a form of counterparty risk involving both credit risk and liquidity risk.

One example of valuation risk is particularly important, which is the collateralised trading of the interest rate derivatives under a credit support annex (CSA). Many companies enter into derivatives without collateral, but when they do the valuation risk is particularly important since the MTM of the hedge impacts the posting of the collateral. When companies enter into long-dated interest rate hedges under a CSA, they have to balance the MTM volatility against the goals of the hedge.

Let us assume that a company enters into a 10-year interest rate swap whereby it receives a fixed coupon of 2% and pays Libor, which is initially 1%. The initial MTM is zero. If after one year the swap rate goes up to 2.5%, the MTM of the swap becomes negative to the company, so it has to post collateral. However, if the Libor does not change, at every settlement date the company still receives the difference between the fixed leg and the Libor – ie, 1%. Due to regular settlements the company has a cashflow benefit, but due to the collateral it has a cash outflow. The second impact can be much larger than the first, and therefore the pros and cons of CSAs for interest rate risk management have to be carefully weighted. We discuss this in Chapter 31.

Ways of mitigation

To mitigate these risks, derivatives used by Media Corporation must have the following characteristics:

- easy to price and measure;
- easy to unwind;
- liquid in the sizes needed; and
- have an acceptable worst-case scenario.

Media Corporation should clearly state to all stakeholders that the objective of risk management is to provide a prudent management of the market risk, and therefore the use of derivatives is intended to add a level of flexibility in risk management and not as an endorsement of trading activity. Normally, this is part of the investor communication. For all derivatives, the following limits must be in place:

- limits on authorised instruments (swaps, caps, collars, swaptions and swaption collars, etc);
- instrument exposure limits (notional, maturity, etc);
- limits on financial counterparties⁵⁵ See Chapter 27 for more detail. (credit rating, concentration, credit default swaps, CDS, etc);
- timing limits (on how long the exposure can be left unhedged, etc); and
- aggregate portfolio limits (sensitivity to market moves, VaR, CFaR etc).

As an example, we show here the limits that Media corporation adopted.

- Exposure limits by type:
  - hedge accounting: 50–70%;
  - non-hedge accounting: 20–25%; and
  - not hedged (floating): 5–30%.
- Delegated authority for interest rate hedging by notional:
  - treasurer: up to EUR 100 million;
  - financial director: up to EUR 250 million;
  - CFO: up to EUR 500 million; and
  - CEO: above EUR 500 million.
- Hedge timing:
  - hedge accounting: to be implemented within three months of the decision; and
  - non-hedge accounting: to be implemented within one month of the decision.

In addition, Media Corporation specified limits on the counterparty risk, which we will discuss in Part IV.

Limits on non-hedge accounting

As non-hedge accounting transactions introduce additional variability on the income statement due to the absence of hedge accounting treatment, there are additional limits on these transactions. The maximum accounting loss is defined in any given period as a given percentage (for example, base case = 5%) of the EaR at the 95% confidence interval. The maximum accounting loss expresses the potential negative impact of the non-hedge accounting portfolio on the income statement in a 95% worst-case scenario of market moves. For example, if five-year VaR at 95% of the non-hedge accounting transactions is EUR 10 million and the five-year ICaR at 95% is EUR 100 million, that means that 10% of the total interest rate risk is caused by MTM volatility of the non-hedge accounting portfolio, which exceeds the 5% limit and must be halved.

The maximum accounting loss is checked periodically by comparing the VaR of the non-hedge accounting portfolio against maximum loss. In the case of a material breach of policy, processes must be in place to escalate the incident up the reporting chain to investigate the reasons for the breach and agree remedial action.

Accounting treatment

In setting up the risk management policy (not just on interest rates but any source of risk–currency, commodities etc), the treasury team must work closely with the internal accounting team to understand the implications of various hedging strategies. This is particularly important for interest rate derivatives, since they are normally longer dated than other hedges and therefore the potential accounting implications can be more significant. A detailed accounting treatment of derivatives (see Ramirez, 2015) is outside of the scope of this book, but we briefly summarise the treatment of three main categories of interest rate hedges in Table 9.2

Table 9.2 Accounting treatment of interest rate hedges

Strategy	Hedged risk Hedge type	Derivative accounting	Hedged item accounting
Floating rate debt swapped to fixed rate	Benchmark Cashflow interest rate⁶⁶ For example, a EUR swap-based discount rate.	Changes in value recorded in equity and reclassified to earnings when interest payments made	Floating rate debt is carried at amortised cost
Fixed rate debt swapped to floating rate	Benchmark Fair interest rate value	Change in value recorded in earnings	Carrying value adjusted⁷⁷ Adjusting for movements in hedged risk differs from the MTM of hedged risk as the hedged item is adjusted to reflect the impact on fair value of movements in the benchmark interest rate. The amount of the adjustment considers only the impact of movements in the discount rate, and ignores movements in the spread over Euribor as this spread is not hedged. for movements in hedged risk
Anticipated issue of debt (“prehedging”)	Interest rate Cashflow	Changes in value recorded in equity and reclassified to earnings when interest payments made	Forecasted debt issuance is off balance sheet

Furthermore, under IFRS9, hedge accounting and risk management policy must be aligned.

RECOMMENDATIONS

After analysing the best practices in risk management and how they apply to Media Corporation, we came up with the following recommendations:

- a dynamic hedging approach should be adopted;
- the fixed-floating mix of debt should be further studied to determine the appropriate policy for Media Corporation’s risk appetite; and
- as an initial choice, a floating proportion of debt should be targeted around 35%, to be increased in line with the planned deleveraging.

PRACTICAL CONSTRAINTS

Most multinational companies have in place an interest rate risk management policy that is well-established and has withstood the test of time. Occasionally, companies may decide to review and update this policy. For that, they consult their banking counterparties, treasury consultants and sometimes friendly peers from other sectors. In this chapter, we hope to have covered the main areas that the company should consider, but in real life there are clearly many constraints and additional considerations that the company takes into account – eg, the current policy, the time and resource limitations in terms of policy implementation and the views of the management (which sometimes broaden the range of possible solutions and sometimes, unfortunately, limit it).

CONCLUSION

In this chapter, we reviewed the main qualitative aspects of the interest rate risk management policy. It is important to stress that all companies have a slightly different set of priorities when it comes to managing risk, and that therefore what we have shown in this case is just a sample of one such study. We briefly touched upon the subject of the optimal fixed-floating mix and duration, which is discussed in greater detail in the next chapter.

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The Handbook of Corporate Financial Risk Management (2nd Edition)

How to Develop an Interest Rate Risk Management Policy

Stanley Myint and Fabrice Famery

BACKGROUND

COMPANY OBJECTIVES

ANALYSIS

STEP 1: FROM SCOPE TO PORTFOLIO CONSTRUCTION

Scope of risk management policy

Risk management approaches

Optimal fixed-floating mix

Peer group analysis

Use of options

STEP 2: ORGANISATIONAL ISSUES

Processes and organisation

Performance measures

Benchmarking

STEP 3: DERIVATIVES RISKS AND ACCOUNTING TREATMENT

Derivatives risks

Ways of mitigation

Limits on non-hedge accounting

Accounting treatment

RECOMMENDATIONS

PRACTICAL CONSTRAINTS

CONCLUSION

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