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Corporate Financial Risk ManagementManaging Interest Rate Expense Flows at Risk
However, if the last three years of market activity is any indication of the future, the forecasted interest expense fl ows under
current market conditions do not necessarily infer what the actual interest expense fl ows will be. To that end, it is crucial to
assess what are the forecasted interest fl ows under stressed market conditions?
In the below graph, there is an illustration of what the forecasted semi- annual interest expense fl ows will be over the next
three years assuming a parallel 100 basis points shock across the yield curve as of the issue date:
It is evident that there is a signifi cant impact on the forecasted interest expense fl ows. Specifi cally, interest fl ows increase
to an aggregated -7.442MM EUR from -4.8MM EUR, or ~ 65% increase from normal market conditions. As a corporate risk
manager, it is essential to understand the market risk associated with the fi rm’s interest rate exposure. As seen from the
Global Financial Crisis, interest fl ows were not what they were originally forecasted to be under normal market conditions!
Many corporations may stop at the point of stress testing for quantifying their risk exposure. However, to ensure a corporation’s
risk management strategy provides a holistic view to measuring risk, it is essential to also understand what interest expense
fl ows are at risk under a simulated environment in a specifi ed time horizon. This leads us to the last question in quantifying
risk: What are the forecasted interest fl ows are at risk under a simulated market environment under a specifi ed time horizon?
*Please not the 1st period shows less interest fl ows under stressed conditions since the rate fi xing has already been set, therefore only showing discounting implications.**HY = Half Year
We can see from the graph that interest fl ows actually increase and an aggregate basis to ~-5.291MM EUR, about 500K
higher than without hedging with an IR swap. This increase can be attributable to the fact that half of the interest fl ows are
locked into a fi xed rate of 1.927%, which is actually higher than the short end of the 6M EURIBOR curve under stable market
conditions. However, in prudent risk management it is not always about minimizing risk under normal market conditions, but
it is more so relevant for risk reduction to adverse market environments.
Below is a depiction of the aggregated interest fl ows for the FRN + 50% IR swap under stressed market conditions (100
bps shock):
The aggregate interest fl ows in this case are ~-6.48MM EUR, which is about a 900K EUR savings from the un-hedged FRN
under stressed market conditions. This illustrates a perfect example of how the value of locking in half of the interest fl ows
at 1.927% saves the corporation money in an adverse market environment.
The last step to effectively managing interest rate exposure is to understand the effect the 50% IR swap has on the CFaR
simulation viewed above for the un-hedged FRN. Below is the chart delineation (red bars):
*Please not the 1st period shows less interest fl ows under stressed conditions since the rate fi xing has already been set, therefore only showing discounting implications.**HY = Half Year
We can see from the graph that interest fl ows decrease on an aggregate basis to ~-4.1MM EUR, about 700K less than an
un-hedged position. This decrease also illustrates the benefi t of using an interest rate cap instead of an interest rate swap to
hedge the FRN. Since the optionality of the cap allows the corporation to only fi x the interest rate fl ows in higher yield curve
environments, the corporation still benefi ts from the downside effect of interest rates.
Now let’s look at the chart of the aggregated interest fl ows for the FRN + 50% IR cap under stressed market conditions (100
bps shock):
The aggregate interest fl ows in this case are ~-5.6MM EUR, which is about a 1.8MM EUR savings from the un-hedged FRN
under stressed market conditions, and a 900K EUR savings of the 50% IR swap hedge. This is yet another example of how
powerful the IR cap is from a hedge standpoint and the benefi ts it provides under normal and stressed market conditions.
The fi nal analysis to be done on the analysis of the IR cap hedge is to look at the CFaR simulation over the 3 year time
period:
*Please not the 1st period shows less interest fl ows under stressed conditions since the rate fi xing has already been set, therefore only showing discounting implications.**HY = Half Year