A company, by definition, takes risks. Business risk, linked to its specific activity, related to commercial or industrial operations, depending on the sector in which it operates. This is not the case of financial risks. Probably, the entrepreneur (or the majority of shareholders) does not expect that the company will also assume financial risks, the typical risks of a bank or of a trader. One of these financial risks comes from the company’s borrowing costs.
1. The financial risk
Let’s start with a concrete example. “I’m considering a three-year loan with my bank in order to invest in new production lines. The interest rate is determined every three months based on Euribor. My bank offers me a fixed rate. What is best for my company?”.
That is, floating or fixed rate loan?
To answer this question correctly you must have in mind that the interest rate is a financial risk. The financial risk intrinsic in the fluctuation of interest rates, which determine the cost of debt. But if it’s normal to take own business risks, it is equally important that the financial risks are well managed, not to have a negative impact on the income statement. And this is even more important in periods when the economy and the markets are in crisis and the cash flows of the companies can be seriously exposed to a liquidity crash.
Well, turning on a loan whether it is a floating rate or a fixed rate, the company is exposed to financial risk. Why? We analyze quickly the two instruments.
– Floating rate: the company is subject to fluctuations in interest rates, when they rise, the costs of financing increase.
– Fixed rate exposes the company to decreases in interest rates, because the financial costs remain unchanged, the company cannot benefit from the reduction in interest rates.
Figure 1 – Interest rate curve – Quotation in Euro interest rates for maturities ranging from 9 months to 8 years (the picture is taken from the service provided by the site www.ekuota.com).
Figure 2 – the graph shows the historical prices of the 3-month Euribor rate
2.FLOATING RATE LOAN
What is the consequence of the interest rate risk for a company?
Usually the bank granted the loan on condition that the company comply with an covenant i.e. the interest coverage ratio (calculated as the ratio between operating income and financial expenses).
If the interest rate increases, the borrower:
–may no longer be able to pay a greater amount of interests;
-or might be able to pay more interests but not to comply with the covenant.
If the covenant is not respected, it would require a costly negotiation with the bank, in order to keep the funding and avoid a liquidity crisis.
Thus, a company with a floating rate loan may wish to modify the terms of payment of the interest, transforming the variable payment in fixed coupons on a predetermined rate for the entire duration of the loan.
Doing so the company would have lock the financial burden due to the loan till maturity. No more uncertainty about the amounts to be paid for the loan.
3. THE RISKS OF A FIXED LOAN
We’ve looked at the impact on the income statement arising from the increase in interest rates if the company takes out a floating rate loan. But what if the company is financed at a fixed rate? In this case, what is the financial risk?
If interest rates fall, a company with a fixed rate loan does not benefit from this decrease. In the income statement the financial burden does not fall.
The income statement is burdened by an amount of borrowing costs higher than those of another company that has a floating rate loan.
4. WHAT DECISION TO TAKE
In summary, when the company takes out a loan, it also acquires a financial risk that must be managed as such. Let’s see how to get to a choice between floating rate and fixed rate.
The three steps are:
1. analysis of the market scenario;
2. measurement of risk;
3. identification of sustainable risk limits.
5. ANALYSIS OF THE MARKET SCENARIO
The current global interest rates scenario is currently determined by the Fed’s monetary policy (the Central Bank of Washington). The Fed is about to abandon its expansionary monetary policy and gradually begin to withdraw the liquidity of the markets. This scenario is reflected in the current prices of interest rates in the dollar area, but the euro area.
The prices of the current interest rates are on the rise with increasing maturity. The 3-month Euribor is equal to 0.28% , the Euribor at 6 months was 0.4 %, the 1-year rate is 0.5%.
As shown in Figure 1, the graph of interest rates is an upward sloping curve: the long-term interest rates are higher than short-term ones .
Concerning the euro – zone, market expectations are for a steady increase in interest rates for all maturities.
The ” forward rate ” (see Figure 3 and 4) is a summary of the average forecasts of future market rates . The “forward rates ” represent the today quotation for an interest rate of 3 months, 6 months or 1 year .
Comparing Tables 3 and 4 shows that for the euro – zone, the increase in interest rates is expected in a much more gradual way compared to the dollar.
Figure 3 – Euro Forward Interest rates
Figure 4 -USD Forward Interest Rates
However, we must take into account some possible threats to this geo-political predictions that could hurt. Especially for developing countries (eg. surprises on data from China’s growth) are possible risks that are now considered remote, but that would lead to judge the euro and US dollar-area as a “safe haven”. In this case, the scenario would be dramatically reversed: the interest rates of both areas could fall.
The interest rate risk is the risk inherent in the indebtedness. The main effects are those related to the impact on the income statement. The financial risk changes the interest expenses and the final economic result.
The interest rates financial risk has two main consequences:
–Change the cost of interest expense or the net profit. This is usually the key risk that companies consider;
–Change the liquidity profile of the company. The lending banks may withdraw or worsen the conditions of the loan if the contract terms (covenants) are breached.
Ultimately, the consequences could jeopardize the economic margins, but also the liquidity of the company .
To decide whether it is better to finance the company at a floating rate or at a fixed rate are therefore two evaluations are required, which at first sight might be rather trivial and they are not:
1. measure the impact of the financial risk on the company;
2. determine what degree of risk can be sustainable.
We have seen what is the current market scenario. Financial operators expect a gradual increase in interest rates in the dollar and to a lesser extent also in the euro area .
Next time we will look at how to measure the interest rates risk and then how to get prepared for the decision whether to borrow at a fixed rate or at a floating rate .
Risk-free choices do not exist. Every decision involves opportunities and threats that need to be managed in the case of fulfilling of an unexpectedly scenario.