Managing of Interest Rate Risk - Essay Example

Name : xxxxxxxxxxx Institution : xxxxxxxxxxx Course : xxxxxxxxxxx Title Managing of Interest Rate Risk Tutor : xxxxxxxxxxx @2010 Introduction Interest rate risk can be defined as risk that is found within assets that are interest bearing such as a bond or a loan, as a result of probability of change that can occur in the asset value due to variability of interest rate (Jonathan2007). Such kind of variability or changes frequently impact securities adversely and can further affect investments made by a business. The concept of management of interest rate risk is a very essential and assorted instrument that is devised in order to tackle the phenomena of interest rate risk, as a result a corporate treasure should be very keen in handling aspects of Interest rate risk. This particular presentation aims at evaluating the major factors that a corporate treasure should consider in the process of managing interest rate risk. Secondly the presentation will cover the strategies that can be adopted in order to effectively manage interest rate risk for their companies. In addition the analysis will cover the limitations of the interest rate hedging strategy. Factors to consider in Managing Interest Rate Risk A corporate treasure should make certain that there is satisfactory separation of duties in the potential elements of the risk management process, in order to eliminate any sort of conflict of interests that may arise. The treasurer should ensure that there is no chance of individuals investing risk taking positions which may influence inappropriately the essential functions of the risk management procedure such as enforcement of procedures and polices and development. The establishment of monitoring, control and measurement functions that outline well defined duties assist in the reporting of risk exposure directly to the management. If possible the corporate treasurer can also create an independent unit that can assist in the monitoring, measurement and control of interest rate risks. Another essential factor that a corporate treasurer has to consider in managing interest rate risk involves having a sufficient internal controls system over the process of interest risk management. A fundamental element of the internal control system entails regular evaluations and reviews of how effective the system is, were appropriate, making certain that the relevant internal controls enhancements are developed. The outcome of the identified reviews should be accessible to the appropriate supervisory authorities (Helen 1996). Assessment of whether the internal measurement system of the business effectively captures the interest rate risk outlined in the records of the business is another essential aspect of consideration. If the internal measurement system of the business does not effectively capture the interest rate risk, then the corporate treasurer must find mechanisms of bring the system to the intended standard. In order to effectively exposures of interest rate across the business, it is essential for the results of the internal measurement system to be made available. The internal measurement system is usually expressed in terms of threat to economic value through the utilization of an interest rate shock that is standardized. If the business is not embracing the interest rate risk levels as highlighted by the records, then the corporate treasure should consider undertaking remedial action, which requires the business to either hold a specified additional capital amount or reduce its risk (Jonathan2007). Monitoring, measurement and control functions are also essential factors to be considered in the management of interest rate risk. It is essential for the business to have measurement systems of interest rates that capture or incorporate every material source of interest rate risk and further make assessment of the impacts of changes in interest rates in the operations of the business. As a result it is essential for the corporate treasurer to clearly understand the assumptions that underlay within the system, which can be done through various methods which include; Establishing operations limits that can sustain exposure with consistent levels with the internal process. The business should measure it susceptibility to loss under market conditions that are stressful this includes splitting key assumptions and then utilizing the results when reviewing and establishing limits and policies for interest rate risk. The organization should also have an effective communication system that is to measure, monitor and control and further report any sort of exposure in interest rates. Reports must be presented on timely basis to the senior management. Strategies to adopt in the management of Interest Rate Risks Sound management of interest risk involves the adoption of fundamental elements in the management of liabilities, assets and instruments of off-balance sheet. One of the main strategies that can be adopted to effectively manage interest rate risk involves the formulation of adequate risk management procedures and policies. It is vital for the interest risk procedures and polices to be clearly defined and in addition they have to have in consistency with the complexity and nature of the activities undertaken by the organization. The adopted policies should be made applicable within a consolidated basis, as appropriate to individual affiliate level, essentially when it comes to recognition of the barriers to cash movement that can occur among affiliates. The essence of adoption of clearly defined procedures and policies is for controlling and limiting interest rate risks. The procedures and policies should also outline lines of accountability and responsibility over the aspect of management of interest rate risk, define clearly authorized instruments of position taking opportunities and hedging strategies. In addition the adopted policies should be tools for identification of quality parameters that define the interest risk level that is acceptable and required by the business. Timothy (2004) highlights that; it is essential to periodically review all the interest rate risk policies in order to attain better management strategies. Another important strategy that can be adopted in the management of interest rate risk is for the senior management to have interest rate risk oversight. Effective oversight by the board of directors and senior management is a very vital element in sound management of interest rate risk. It is vital that these personnel’s are made aware of their roles in regards in the management of interest risk and that they can efficiently manage the task of managing and overseeing interest rate risk. The corporate treasure should ensure that the boards of directors are regularly informed pertaining exposure of interest rate risk, in order for them to promptly monitor, asses and control the risk. The board of directs have to make approval of business policies and strategies that influence and govern the interest risk of the business as a result it is essential for them to be well informed concerning the level and nature of interest risk. The boards of directors also encourage discussions between members of the organization and other external organizations concerning legal issues and techniques of risk management. The senior management on the other hand should ensure that the structure of interest rate risk level are well managed and that and that appropriate policies and procedures are followed for the purpose of limiting the number of risks. The management should also ensure that limits on risk taking are established, sufficient internal control and establishing adequate standards for measuring of risks (Helen 1996). Collars are categorically another suitable strategy of management of interest rate risk. A collar comprises of an interest rate floor and cap. In order to enter into a collar, the business can buy an interest rate cap and later sell an interest rate floor within the derivatives market. For instance in the contest of the banking sector , the interest rate cap is a series of call options that are stipulated at a similar exercise rate and have expiry dates which underlying liabilities are expected to reprice. The interest rate floor on the other hand is as series of put options for interest rates that are stipulated at a similar exercise rate and have expiry dates as which underlying liabilities are expected to reprice. Incase interest rates fall, the interest rate floor requirement is that the bank pays the buyer the difference between LIBOR and the floor rate. As a result a bank has knowledge that its interest rate expenses of the future whether rates are to rise or fall. By engaging in the collar a bank is neither long nor short of interest rates within the derivatives market. Within an environment were interest rates are frequently rising, a bank that has the objective of offsetting the interest rate risks only can make can purchase the interest cap only. The adoption of measurement systems that capture all material resources associated to interest rate risk and the effects of changes is another essential strategy in managing of interest rate risk. Depending on the range of activities and the complexity of the business, the corporate treasurer should consider adopting measurement systems that can effectively assess the impacts of rate changes on both economic value and earnings. The adoption of measurement systems should facilitate the following essential aspects of risk management; Assist in the assessment of all the material interest rate risks linked to the businesses liabilities and assets Incorporate exposure of interest rate exposure risks that arise from the scope of trading activities of the organization. Evaluate the material sources of interest rate risk, including the yield curve, option and basis risk exposure and repricng. Offer precise treatment for instruments that may significantly affect the position of the business Circumstances when specific products are appropriate for hedging. Hedging enables a business to manage risk and also lessen potential risks that may affect the business. Within the forex market if the management does not hedge then they can never be sure when the currency rates may remain the same as a result if the rates move unfavorably it would be very costly for the business. The adoption of a good hedging strategy can assist the forex business in terms of eliminating the currency exposures and further cater for risks that are associated to currency movement. There are various products of hedging within the forex market, which entail the buying of foreign currency what is presently referred to as exchange rates. One of the common hedging products in the forex market is the concept of currency options. Currency options are usually bought at a bank. A currency option provides the holder the right to buy or sell a sum of currency at particular set price before or on a given date. A currency option is intended to have strike a price which is the amount, that a currency can be sold or bought (Fx Trade, Currency Hedging Primer 2008). The basic question that can be asked is why is hedging necessary within the currency option? Many companies are frequently faced with the challenge of how best to deal with the phenomena of currency exposure. In many situations purchases or signed contacts in different currencies that are to occur in the future may result to costs that are unplanned incase currencies experience a fluctuation that is unfavorable, and this situation can actually be very costly to a business. It is therefore essential to use the hedging strategy in order to eliminate risks associated to currency movements and the currency exposure. Luckily within the forex market various vehicles for undertaking hedging forex risk are available. They either involve methods of purchasing foreign currency at the present exchange rate or also finding a way of to purchase foreign currency at later date at the present fixed exchange rate (Fx Trade, Currency Hedging Primer 2008) Hedging therefore provides an opportunity to manage and lessen potential risk. As a result if one does not undertake the hedging practice within the forex market context then the speculations they use may turn out to be costly. The disadvantage linked to hedging in the context of currency options involves aspects such as There are likely chances of getting a competitive interest rate within the margin account Future contracts do not only entail a spread but also the payment of a commission The face value of contracts made in the future are usually fixed as a result it is difficult to make estimations of the exact value of the currency rate. Conclusion A corporate treasure can effectively mage interest rate risk through the application of viable measures that can result to the desired objective of risk management. It is therefore essential to integrate the strategies highlighted in the above presentation in order to effectively counter the negative impacts that may be caused by interest rate risk and also the negative aspects of hedging. Given the enormous expansion in the use of derivatives by non –financial and financial sectors, there is widespread proof that derivates can bring benefits in form of increased firm value. Bibliographies Jonathan, A.(2007). Risk management and derivatives use in Australian firms. Journal of Asia Business Studies http://findarticles.com/p/articles/mi_6777/is_2_1/ai_n28451604/?tag=content;col1 Helen, S. (1996). Managing interest rate risk, Journal of Financial and Quantitative Analysis Cambridge University Press . Fx Trade. Currency Hedging Primer(2008). Retrived Read More