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Jana Schönborn
Financial Risk Management - Management of Interest Risk from a Corporate Treasury
Perspective in a Service Enterprise
ISBN: 978-3-8366-4385-6
Herstellung: Diplomica® Verlag GmbH, Hamburg, 2010
Zugl. Fachhochschule für Technik und Wirtschaft Berlin, Berlin, Deutschland,
Bachelorarbeit, 2009
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© Diplomica Verlag GmbH
http://www.diplomica.de, Hamburg 2010
Ji:
Chinese character
is part of both meanings,
risk and
Chinese character that
is part of both meanings,
and opportunity.
Table of Contents
List of Figures ... III
List of Abbreviations ... IV
1.
Introduction ... 1
2. Essentials of Financial Risk Management in a Service Enterprise... 2
2.1.
Why Manage Financial Risk? ... 2
2.2.
Classification of Interest Rate Risk in the Framework of Risk Management ... 3
2.3.
The Financial Risk Management Cycle ... 5
2.4.
Insight into the Service Sector and its Current Trends with respect to
Financial Risk Management ... 7
3. Treasury as a Central Institution of Financial Risk Management ... 10
3.1. Corporate Treasury Risk Management and its Influencing Factors ... 10
3.2. Financial Risk Management within the Scope of the Treasury Risk Policy ... 11
4. Quantifying Interest Rate Risk ... 13
4.1. Understanding Interest Rate Risk ... 13
4.2. Duration and Convexity ... 15
4.3. Value at Risk ... 18
4.3.1. The Concept of Value at Risk ... 18
4.3.2. Historical Simulation ... 21
4.3.3. Variance-Covariance-Approach ... 22
4.3.4. Value at Risk of Derivatives ... 25
4.4. Cash Flow Mapping ... 25
4.4.1. Determining the Cash Flow Structure ... 25
4.4.2. Sensitivity Mapping ... 27
4.4.3. Variance Mapping ... 29
4.5. Implications for a Service Enterprise ... 30
| II
5. Interest Risk Management Techniques ... 33
5.1. Hedging ... 33
5.1.1. Introduction to Hedging ... 33
5.1.2. Symmetric Hedging Instruments ... 34
5.1.2.1. Forward Rate Agreement ... 34
5.1.2.2. Interest-Rate Future ... 35
5.1.2.3. Interest-Rate Swap ... 36
5.1.3. Asymmetric Hedging Instruments ... 37
5.1.3.1. Option ... 37
5.1.3.2. Cap, Floor and Collar... 40
5.2. Implications for the Portfolio Alignment of a Service Enterprise ... 41
5.2.1. Duration ... 41
5.2.2. Benchmark ... 43
5.2.3. VaR Limit ... 43
6. Case Study ... 45
7. Conclusion ... 52
8. Appendices ... 54
9. Bibliography... 61
| III
List of Figures
Figure 1: Overview of the Risks Facing an Enterprise ... 3
Figure 2: The Risk Management Cycle ... 5
Figure 3: Risk-Tolerability Matrix ... 6
Figure 4: Risk-Time Relation ... 11
Figure 5: Euro Area Yield Curve (Spot) ... 14
Figure 6: Price-Interest Relation ... 16
Figure 7: Density Function of the Normal Distribution ... 19
Figure 8: Relation between the Z-Score and the Level of Confidence ... 20
Figure 9: Interest Rate Risk of Positive and Negative Cash Flows ... 26
Figure 10: Gross Value Added in Germany ... 7
Figure 11: Sales Statistics of Selected Branches of the German Service Sector ... 8
Figure 12: Overview of Derivative Instruments ... 33
Figure 13: Profit-Loss-Profile of a Long (left) and a Short (right) FRA ... 35
Figure 14: Intrinsic Value of an Option ... 37
Figure 15: Profit-Loss-Profile of a Long (left) and a Short (right) Call ... 38
Figure 16: Profit-Loss-Chart of a Long (left) and a Short (right) Put ... 39
Figure 17: Put-Call-Parity ... 40
Figure 18: Summary of Hedging Strategies ... 41
Figure 19: Selection of a Benchmark with Optimum Interest Cost for Enterprises
with a Debit Carryover ... 42
| IV
List of Abbreviations
AktG
Aktiengesetz (Company Law)
BilReG
Bilanzrechtsreformgesetz (Accounting Law Reform Act)
CAPM
Capital Asset Pricing Model
CFO
Chief Financial Officer
CRO
Chief Risk Officer
DAX
Deutscher Aktienindex (German Stock Index)
DCGK
Deutscher Corporate Governance Kodex
(German Corporate Governance Code)
E-SOX
The European Sarbanes-Oxley Act (also 8
th
Company Law)
ECB
European Central Bank
EU
European Union
EUREX
European Exchange
EURIBOR
Euro Interbank Offered Rate
EWMA
Exponentially Weighted Moving Average
Fed
Federal Reserve (of the United States)
FRA
forward rate agreement
GmbH
Gesellschaft mit beschränkter Haftung (limited liability company)
GmbHG
GmbH-Gesetz (Limited Liability Company Law)
HGB
Handelsgesetzbuch (German Commercial Code)
IFRS
International Financial Reporting Standards
k
correlation coefficient
KonTraG
Gesetz zur Kontrolle und Transparenz im Unternehmensbereich
(Corporate Sector Supervision and Transparency Act)
LIBOR
London Interbank Offered Rate
LIFFE
London International Financial Futures and Option Exchange
m
million
NYSE Euronext New York Stock Exchange Euronext
OTC
over-the-Counter
OECD
Organisation for Economic Co-operation and Development
P/L
profit and loss
resp.
respectively
SE
Stock Exchange
SOX Act
Sarbanes-Oxley Act
VaR
value at risk
| 1
1.
Introduction
The importance of a systematic risk identification, measurement and management as a
management duty has increased in recent years. After risk management and interest
risk management in particular was primarily relevant for banks in the past, it is a
crucial competition factor for all enterprises today. Especially since the recent
financial crisis treasurers are far more risk conscious and companies are reassessing
their financial risk management procedures.
The most important parameter for the cost of financing and the return of capital
investments is the interest rate. However the interest rate is subject to fluctuations,
what constitute the interest rate risk the company is exposed to
1
. With increasing
volatile financial markets and global competition CFOs are focusing more and more
on an efficient measurement and management of interest rate risk.
2
In this context this academic paper aims to point out the risks of an adverse change in
interest rates for a corporate portfolio of interest-bearing positions and show
possibilities to measure and manage these risks. The 2nd and 3rd sections set the
scene for interest risk management in a corporate treasury of a service enterprise by
providing essential knowledge about financial risk management and giving an insight
into the characteristics of a service enterprise as well as the responsibilities of a
corporate treasury and the factors that influence the treasury risk management
approach. In section 4 and 5 respectively follows a process-oriented instruction of
how to quantify interest rate risk and how to manage it. Besides the risk measures
duration and convexity (4.2), two different approaches to value at risk, the historical
simulation (4.3.2) and the variance-covariance-approach (4.3.3), will be examined.
The value at risk is a measure to quantify risk that allows to express the risk exposure
with a single absolute figure. For the management of the interest rate risk an overview
of possible hedging instruments to reduce interest risk exposure will be given and
their different strategies examined (5.1). All approaches will be measured against their
practical feasibility and for both, the quantification and the management of interest
rate risk, implications for the implementation in a service enterprise will be provided
(4.5; 5.2). This will also be illustrated in a case study in section six. The conclusion
serves for a critical reflection of all methods being discussed.
1
The central bank sets the base rate for inter-bank lending that in turn affects the market interest rate. Important central banks are
for instance the ECB for the Euro area and the Fed for the United States.
2
Sanders, 2009
| 2
2.
Essentials of Financial Risk Management in a Service Enterprise
2.1.
Why Manage Financial Risk?
Centralized risk management is useful to any corporation that has exposure to financial risks.
3
This statement can be backed up by many aspects a firm shall consider. The first
compelling reason for a company to make a point of striving for an effective financial
risk management is the comprehensive regulatory framework. After KonTraG
demands regular monitoring and external reporting of the key risks since 1998, some
other regulations have been passed in recent years.
4
A good example is the new Basel
II Accord (2007), that caused changes in the bank lending process. The relation of the
total risk exposure to the equity capitalisation and the amount of working capital
defines the probability of insolvency and thus influences the rating. A bad rating will
lead to higher cost of borrowing or no financing at all. A prudent treasury risk
management will avoid financial distress by stabilising cash flows. This results in a
better capacity to serve loans and lowers the possibility of insolvency. With a good
rating a company's financing options will be enhanced, not only in terms of an easier
approval process but also through reduced financing cost. This is even more important
in times when the risk appetite of banks is low and sourcing of finance in general
becomes difficult. Thus with risk adjusted equity capitalisation calculations, the risk
management defines the minimum amount of equity needed to cover possible losses.
5
According to the CAPM the shareholders expect a higher return when making a more
risky investment. Reducing the fluctuations of cash flows will advance the ability to
plan and control. Thus predictable cash flows will not only reduce risk but also lead to
less cost of unplanned financing and thus have a positive effect on the expected profit.
Therefore it is a company's objective to reduce the volatility of returns in relation to
the market in order to optimise shareholder value. Moreover unexpected financial
losses could have an adverse impact on a company's chosen strategy. The strategy
might than need to be modified, postponed or completely cancelled. Financial risk
management provides transparency of the risk situation and the possibility to control
such losses by weighting the expected earnings of a business decision against the risks
arising with it.
6
3
Jorion, 2007, x
4
Since the legal foundation of the financial risk management is not the main focus in this paper but should also not be
disregarded completely, a list of the most important regulations can be found in Appendix 1.
5
Gleißner, 2007
6
Association of Corporate Treasurers, 2009
| 3
Overall it can be said, that a proactive addressing of financial risks may provide an
organisation with a competitive advantage. Thus the design and implementation of an
appropriate risk management system and its ongoing revision as external conditions or
internal requirements change, is a core strategic tool and ensures to identify, measure
and manage the firms risk exposure in an effective way.
7
2.2.
Classification of Interest Rate Risk in the Framework of Risk Management
Since there is no consistent definition of the term risk, the understanding used in this
paper should be determined as follows:
"Risk can be defined as the volatility of unexpected outcomes, which can represent the
value of assets, equity or earnings. Firms are exposed to various types of risks, which
can be classified broadly into business and financial risks."
8
Whereas KonTraG only
considers negative deviations of actual figures to the projected outcome as a threat,
BilReG also includes positive ones. The latter is also reasonable from a financial point
of view, since positive and negative deviations might offset. Risk management is
defined as the systematic treatment of risks, including all processes involved in
quantifying business and financial risks and their corresponding management.
9
Figure 1: Overview of the Risks Facing an Enterprise
The main focus of this paper is on interest rate risk and its respective management.
Interest rate risk belongs, together with equity risk, currency risk and commodity risk
to the market risk that is in turn counted among the financial risks of a firm, "[...]
which relate to possible losses owing to financial market activities."
10
Wolke defines
interest rate risk as market interest rate related capital risk, which can occur either as
interest cost or return risk or as present value
11
risk. It is derived from the risk of an
7
Gleißner, 2007
8
Jorion, 2007, 3
9
Wolke, 2008
10
Jorion, 2007, 4
11
The present value of an interest-bearing position is the sum of its discounted cash flows. For more details see section 4.1.
Financial risk
Market risk
Default risk
Interest rate risk
Currency risk
Commodity risk
Equity risk
Liquidity risk
Operational risk
Sourcing / Sales risk
Strategic risk
Political risk
Corporate Gover-
nance risk
Risk
| 4
adverse change in market interest rates and the resulting possibly negative impact on
the firm's profitability or asset value. It is particular significant for capital-intensive
industries and thus for financial institutions. For a corporate, such as a service
enterprise, the impact of interest rate risk depends on the amount of its assets and the
value of interest rate costs to serve its liabilities.
12
Another aspect of interest rate risk that is ignored by Wolke is the macro-economic
interest rate exposure. This is a hidden risk resulting from the sensitivity of sales and
profitability of a firm to interest rate changes. However, this impact is hard to predict
and thus difficult to include in the risk quantification. For a non-financial service
enterprise a direct relationship between the level of interest rates and the success of
the operational business cannot be found. Therefore this risk will be disregarded in
this paper.
13
Interest risk management is the systematic treatment of interest risks facing the
enterprise. It includes all activities involved in defining an interest risk management
approach, measuring the interest risk exposure and subsequently managing it with
appropriate instruments. The first step is the analysis of the portfolio, the measurement
of its interest rate risk and the determination of the possible change of its present value
due to the expected market development. This analysis helps to identify possible
adjustment needs.
14
With modern interest management instruments the structure of the
portfolio can be easily adapted to changed conditions. This means that interest
developments do not have to be accepted, but there is the possibility of hedging
interest rate risks.
With respect to interest risk management a passive and an active management style
can be differentiated. Passive strategies require only minimum hypotheses about the
future market interest rate development and supersede a continuous portfolio
switching. Here one distinguishes between so-called buy-and-hold strategies, where
acquired interest instruments are kept in the portfolio up to their maturity, and index
fund strategies, where the portfolio shall achieve the performance of the market. An
objective of passive control measures is to attain the same returns and the same risk as
a selected benchmark.
15
12
Wolke, 2008
13
Donohoe, 2003, Part 1
14
Scharpf & Luz, 2000
15
Eller, Gruber & Reif, 2002
| 5
The active management by contrast aims to out-perform the benchmark based on its
own interest forecast
16
. According to the expected interest rate development and
following strategic considerations the possibility exists to allow increased cash flows
in certain maturity ranges. Since an active management causes extensive additional
expenditures, a deviation from the benchmark based on the interest forecast makes
only sense, if a higher profit at the same risk or less risk with the same profit can be
achieved.
17
2.3.
The Financial Risk Management Cycle
The process of financial risk management is not isolated, but rather a management
philosophy and should as such be referred to in the context of the company structure
and its external environment. The company should clearly state its objectives
concerning risk management and align all actions aimed at identifying, quantifying,
managing and reporting treasury risks to its business strategy. Furthermore, specific
risks cannot be addressed in isolation from each other; the management of one risk
may have an impact on another. Since strategies need to be refined as business or
market requirements change, financial risk management is not a single action but a
rather dynamic process.
18
Figure 2: The Risk Management Cycle
19
16
Since the core competence of a non-financial service enterprise is generally not in the field of interest risk management, the
quality of an own interest rate forecast has to be challenged. As an alternative also the interest forecasts provided by banks or
independent institutions, as for instance the Feri Finance AG, can be applied.
17
Eller, Gruber & Reif, 2002
18
Association of Corporate Treasurers, 2009
19
HM Treasury, 2004, 13
| 6
The systematic and structured identification
20
of all individual financial risks forms
the basis for an appropriate financial risk management system. Within the scope of the
risk identification the company needs to define its key risks. However there might be
risks of which the company is aware but has decided not to actively manage them.
Based upon the identification of the risk, the extent of it has to be quantified.
21
The consideration of interacting effects of different risks is an important distinction
between the examination of a single risk and a portfolio of risks. The result of the risk
quantification is the basis for the following risk management. Since only the risk that
is decently measured can be managed, the risk quantification has a high significance
within the risk management process and consequently in this paper. The instruments
to manage financial risks can be divided into measures of precaution, transfer,
compensation and diversification.
22
To monitor and control the measured risks on a periodic basis, limits need to be set
according to the risk tolerability of the company. The result can then be illustrated in a
risk matrix.
23
Figure 3: Risk-Tolerability Matrix
The regular reporting of the progress in financial risk management and a periodical
review of the entire process is a controlling tool that helps to refine the approach and
improve strategies. Often a monthly financial risk management reporting on the
outstanding financial exposure and existing hedges combined with action
recommendations is prepared. This report should be easily understood at board level
to allow for an appropriate decision making.
24
20
Since the risk identification is already predefined by the title of this paper, the issue of risk identification will not be addressed
further.
21
Association of Corporate Treasurers, 2009
22
Wolke, 2008
23
Mare, 2008
24
Association of Corporate Treasurers, 2009
im
p
a
c
t
likelihood
tolerability
| 7
In order to achieve the objective of a company-wide consistent risk culture when
addressing financial risks a risk management policy needs to be defined, the treasury
policy derived, and a financial risk management programme implemented. In this
regard expenditure and risk ratios are defined; permanently ex-post analysed and
improved. The ex-post analysis serves as a process back-testing and at the same time
functions as an early-warning-system.
25
2.4.
Insight into the Service Sector and its Current Trends with respect to
Financial Risk Management
Since the service sector is highly homogenous, a definition of the term as well as its
differentiation from other business sectors can be difficult. However, in order to be
aware of the special challenges of the tertiary sector one has to understand the
characteristics that all services combine. First, services are marketable activities,
meaning they produce a benefit that at least theoretically could be rewarded. A further
distinctiveness is the intangibility of services. Although supplies might be used in the
service process, the result remains of an immaterial nature. Since a service is
performed on the customer or on an object provided by the customer, the service
completion is not possible without the customer. Thus the customer supplies external
production factors that are not in the direct sphere of influence for the service provider.
Finally a service is characterised by the fact that it is completed after the agreement
between buyer and seller has been made and in fact is a performance bond. Though,
the last attribute is also true for order-oriented tangible goods.
26
Figure 4: Gross Value Added in Germany
27
25
Association of Corporate Treasurers, 2009
26
Melzer-Ridinger & Neumann, 2008
27
Statistisches Bundesamt, 2009
Primary sector
(agriculture, forestry, fishing)
Secondary sector
(industry)
Tertiary sector
(service)
| 8
The commercial relevance of services is demonstrated by the increasing gross value
added (see Figure 10) as well as a rising number of employees in the tertiary sector.
Developed economies are characterised by a higher proportion of employees working
in the service sector than in the primary and secondary sector. Germany (72.5%) is
along with The United Kingdom (76.3%), Norway (75.7%), Australia (75.1%),
Belgium (73.7%) and Denmark (73.3%) among the OECD economies showing the
greatest employment ratio in the tertiary sector. In 1970 the quota, even in these
countries, was much lower at around 50%.
28
Although the service sector as a whole is growing, especially in Germany (see Figure
4), the operating cash inflows of different branches within the service sector are highly
volatile (see Figure 5). Service enterprises are often facing seasonal fluctuations and
are also highly dependent on the overall economic climate.
Figure 5: Sales Statistics of Selected Branches of the German Service Sector
29
(relative change compared to prior quarter)
Opposing to the fluctuations of the operating cash inflows of a service enterprise, the
out flows are characterised by a high proportion of personnel costs. These are to a
great extent fixed costs at least in the short run. Furthermore the specifics of services,
such as the lack of storability, the restricted automation possibilities, the intangibility
and the resulting difficulties regarding the comparability are a difficult basis for the
controlling function. Therefore the cash flows of a non-financial service enterprise are
much less predictable than for instance the cash flows of a bank or a producing
company.
30
28
Statistisches Bundesamt, 2009
29
Statistisches Bundesamt, 2009
For further sales statistics on the German service sector see Appendix 2.
30
Bruhn & Stauss, 2006
-25
-20
-15
-10
-5
0
5
10
15
20
2003
2004
2005
2006
2007
2008
in %
Automobile trade, service and maintainance
-25
-20
-15
-10
-5
0
5
10
15
20
2003
2004
2005
2006
2007
2008
in %
Wholesale
-25
-20
-15
-10
-5
0
5
10
15
20
2003
2004
2005
2006
2007
2008
in %
Retail
-25
-20
-15
-10
-5
0
5
10
15
20
2003
2004
2005
2006
2007
2008
in %
Hotels and restaurants
| 9
From a study of the financial statements of the 30 DAX-listed enterprises from the
years 2003 and 2004 several statements to the trends in hedging strategies can be
derived. The financial risk is in general managed by a centralised treasury department.
Non-financial institutions are using derivative instruments on an increasing larger
scale to hedge financial risks, but not for trading purposes. Thereby interest rate risks
are after currency risks the most prevailing risks to be hedged. The most often used
interest rate derivatives according to their nominal value in 2004 were swaps, options,
forwards and futures.
31
This can be backed up by a survey conducted by the chair in
finance and bank management of the University of Siegen in 2002, according to which
83.7% of the interviewed non-financial corporates consider the interest rate risk as
relevant and manage it. Though, paradoxically only 76.7% measure the risk. 58.6% of
the firms that quantify interest rate risk use scenarios of parallel yield curve
32
shifts,
but only 29.3% use at-risks-methods
33
.
34
By way of example the Deutsche Post AG as a leading service enterprise for logistics
shall be mentioned. Deutsche Post World Net, with its areas Brief, Express, Global
Forwarding / Freight and Supply Chain / Corporate Information Solutions reported in
its financial statements of 2004 total assets of EUR 153,357m and a nominal value of
all hedging instruments amounting to EUR 45,870m, thereof EUR 39,058m were
interest rate derivatives.
35,36
31
Schmeisser & Hecker, 2005
32
For an explanation of the yield curve see section 4.1.
33
According to Schwabe, 2006 this has not changed in recent years.
34
Wiedemann, 2002
35
Schmeisser & Hecker, 2005
36
According to the annual statements of Deutsche Post World Net for 2008 the nominal value of all hedges is EUR 46.557m.
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