In the previous issue, we saw **the consequences of an interest rate risk for a company**. Now let’s see **how to measure and manage risk**.

We started from the budget of an imaginary company “iHaterisk.” The budget of this company was formulated on the basis of information received from the sales department, the purchasing department and production.

“iHaterisk” has in place a medium-term loan of EUR 5 million with the bank. The interest rate is determined by the loan agreement as the sum of the 3-month Euribor rate (currently 0.3%) and the spread of 3%. The calculation of annual financial expenses is formulated as follows:

Interests: € 5,000,000 x 3.3% = € 165,000.

In Table 2, we see the three-year budget of Ihaterisk. The sales direction expects a slight increase in sales of 2.5% per annum. Operating costs are estimated at 60% of revenues. Taxes are estimated at 33% of gross profit.

**Interest rates, as we saw in the previous part, are expected to increase**. Financial markets estimate a gradual increase in interest rates over the next two years.

Taking into account the forecasts, the borrowing costs for 2014 are calculated assuming the 3-month Euribor rate equal to 0.3%, equal to 1 % for 2015 and equal to 1.5% for 2016.

If the assumptions come true, the company “iHaterisk” does not have any problem about the payment of financial interests.

The assumptions that were used to build the scenario shown in Table 2 (Base case scenario) are the following :

-Revenues up 2.5, % per annum;

-Operating income equal to 40% of revenues;

-3 months Euribor 0.3 % in 2014, 1% in 2015 and 1.5% in 2016.

Now let’s see **what happens if interest rates rise more than expected**. In Table 3, the 3-month Euribor rate has risen to 3%.

In the scenario described in Table 3 although the company has maintained its expected revenue growth and economic margins, was not able to transfer these improvements in net income. The shareholders’ profitability decreased because** profits are down and thus dividends**.

**Given what could happen, how can you manage the financial risk?**

I**NSTRUMENTS FOR INTEREST RATES RISK MANAGEMENT**

The main tools of risk management are **interest rate swaps (Swap) and the Cap**. Some others less used are **Forward Rate Agreement**, **Collar** and **Swaptions**.

**SWAP**

The interest rate swaps or IRS (interest rate swap) **is a contract with a broker to hedge changes in interest rates. A swap allows those who have floating-rate debt to transform it in fixed-rate loan and vice versa.**

In our example, the company “iHaterisk” may decide to enter into a swap agreement with the bank to **convert the interest rate on the loan – that is linked to the price of 3-month Euribor rate – into a fixed rate**.

In this case, the fixed rate offered by the bank is the 2 % that has to be added to the 3% spread.

As a result of the swap contract “iHaterisk” will receive payment of interest on 3-month Euribor rate and will pay a fixed rate (2%). For this reason it is said that “iHaterisk” **is paying fixed rate** **while the bank is paying variable rate**.

For each quarter is detected the 3-month Euribor at the beginning of the period and is paid at the end of the quarter netted with the agreed fixed rate.

If the fixed rate agreed in the swap contract is higher than the Euribor rate (as in the example in Table 6), then the company pays higher interests than it would have paid without choosing a fixed rate.

The price of the floating rate (the 3 months Euribor) changes over time. “Ihaterisk” will have an advantage if the Euribor rate grows to exceed the agreed fixed rate.

Let’s summarize the changes in the cash flow of the company.

The original interest payment related to the floating rate (3 month Euribor) is offset by the fact that the company receives an equal cash flow. Then the company have to pay the fixed rate. So the overall cash flows are transformed as follows:

5mil€ x (Euribor 3M – Euribor 3M + Fixed rate + spread)/4 = 5mil€ x (3%+2%)/4 = 62.500€

**If switching to a fixed rate has been convenient or not is only known ex post, depending on the price of the 3-month Euribor**. The transformation of the fixed rate into a floating rate through the swap agreement will be convenient for the company only if, looking at the total amount of interest paid, the sum of the differences between the 3-month Euribor and the fixed rate (2%) will be positive. Formally:

Σi(Euribor 3Mi – 2%) >0, i = T1, T2,…, Ti,…TN,

Ti is the generic quarterly payment date.

**CAP**

Another widely used tool for the floating interest rates hedging is the CAP. **The Cap is a derivative contract that allows those in debt at a variable rate, to buy protection in the event that interest rates exceed a certain level.**

By purchasing a cap, with the **payment of a premium** at the beginning of the loan, you have the **assurance** that the cost of your loan will never exceed a set level “Cap”.

In the case of “iHaterisk”, if we buy a cap on the 3-months Euribor at 3% (strike) we are sure not to pay more than 6% (3 month Euribor + 3% margin) till maturity of the loan.

**The convenience to purchase a Cap must be verified by comparing it with respect to the purchase of a fixed rate (Swap)**.

**In normal market conditions, the Swap rates are less expensive. But fixed rates do not allow to take advantage of periods of low interest rates.**

If the interest rate (3 months Euribor) grows to exceed the agreed threshold (Cap), then the bank will refund the difference of interests. The bank will pay the difference between the amount calculated on the basis of the floating rate and the amount calculated on the basis of the Cap.

**Swap vs Cap**

Summing up, let’s compare the two tools we’ve seen.

SWAP |
CAP |
||

Pros | Cons | Pros | Cons |

-Allows to fix the costs of financing | -It does not allow to benefit from the reduction in interest rates | -Allows to plan the financial costs within the limits established | -Initial outlay (premium) |

-widely used and relatively less expensive | -Allows to benefit from a period of declining interest rates | -Usuallly less convenient than the swap | |

-It does not require an initial outlay |

**For both there are pros and cons to consider carefully and to compare with the strategic vision of the company**.

The Swap agreement is the most frequently used and offered by financial intermediaries and **does not require the payment of an initial premium** as in the case of the Cap contract.

On the other hand, **the Cap is a kind of insurance** that allows to be protected from expensive increases in interest rates and to **enjoy the possible decrease in interest rates**.

**CONCLUSION**

**Unpredictable movements of prices on financial markets are phenomena which must be taken into account**. Interest rates, currencies, commodities are financial risks that must be managed.

For today’s organizations is clear that fluctuations in financial prices can affect not only the income statement but also **the survival of the company**.

There are various financial instruments available to the corporate finance that should be properly screened having in mind that the **uncertainties of price can not be ignored**. **The trend of global companies is to actively manage risks rather than trying to predict price movements**.

Managers and shareholders should define the strategic objective. Stabilizing cash flows or maximizing shareholder value? Hedging risk completely or partially? Hedging only the extreme risks? None of these questions can be answered in abstract. The correct answer varies from company to company .

I believe that the primary objective of enterprise financial risk management is to reduce as much as possible the probability of failure for the company. The probability that the company does not have sufficient resources to complete its business plans.

Authors: Laura Oliva and Raffaele Zenti