Interest rate risk management technologies have revolved over the years into a more robust and scalable tool to manage the ever growing financial risk that faces modern day financial managers. Interest rate risk if left unmanaged can cause disturbances in the flow of operations in any kind of business. It does not matter whether the business is an international or a domestic business.
Risks in financial management are seen from two perspectives (business and financial). Interest rate exposure falls within bother categories. This article is written to discuss the recent development within interest rate exposure. Other components of total international risks are; political risk and foreign exchange exposure.
DISCUSSION | DEFINITION | MEANING | EXPLANATION OF RELEVANT TERMS
This is a sensitivity analysis based tool used to determine a firms’ stand as far as liquidity is concerned. This is unlike most form of financial risks that are a function of leverage and other variables. This explains why interest rate exposure is both a financial and business risk. All companies irrespective of their; size, capital structure, mode of operation, etc are all exposed to the heat generated by movement in the borrowing and lending rate. There are two main types of interest risks: Basis risk and Gap risk
Basis risk is the misalignment of interest rate bases in select assets and liabilities. Basic accounting tells us that assets and liabilities need to be matched according to their maturity term. This in practice is somewhat difficult to effectively match these it is difficult to find perfect match (even when assets and liabilities have the same maturity terms and same currency denomination for multinational companies), chances are they will have different interest base. Interest rate base is the minimum rate that borrowing and lending cannot go below. A UK parent company with a US subsidiary obviously operate in different market using different base. While UK is basically based on LIBOR (London Inter-Bank Offered rate), the US is based on Prime rate (this is my personal observation). Alternatively, when the value of a particular asset is sensitive to the US dollar six month LIBOR, but with a corresponding liability that is based on the US prime rate. The situation just described makes it possible for movements in interest rate to easily alter the spread (difference) between the interest bases. This is to say that basis risk could be seen as an uncertainty between two interest rate points (this is technically called ‘basis’ which is the difference between present and future price).
Gap risk is the imbalance that arises as a result of rebalancing or re-pricing assets and liabilities that are affected by movement in interest rate. This is more predominant in the real sector of the economy (i.e. non financial institutions). Companies traditionally have lesser interest-sensitive asset in their balance sheet than interest bearing debt.
Net interest income
This is the equivalent of basis risk that is peculiar to financial institutions. This is technically defined as the difference between income in the form of interest from assets and the interest in the form of expenses linked to liabilities. The best way of managing this kind of interest rate exposure is to have a full fledge treasury department with broad mix of experience in the development and use of derivatives.