Interest-Rate Management: Fundamental Considerations

Regula Spottl  • Tomato Treasury Services AG • 8 Mar 2002

Co-authored by Klaus Groner

As the economy in the United States and Europe is expected to recover later in 2002, followed by periods of growth in 2003 and 2004, some currency researchers suggest a change of interest-rate strategy for corporate treasuries.

Specifically, one research company recently suggested to borrow as much as possible in U.S.$ in 2002. They further suggest that the interest-rate levels for the coming years should be fixed as much as possible. And last, they recommend the use of interest swaps (IRS) to switch to longer interest-rate terms at a rate fixed in advance.

Based on our knowledge and experience, we recommend the following thoughts and guidelines when you consider any short-term strategy changes.

1. Short-term changes in the interest-rate market are important

Just consider the surge of 10-year Euro government bonds from 4.03% on Nov. 8, 2001 to 4.77% on Feb. 25, 2002. The same rate declined from 5.08% on May 25, 2001 to 4.03% on Nov. 8, 2001.

2. Using interest rate swaps (IRS) are a must in volatile markets

Only IRS offer the flexibility to reopen the position after either reaching a sufficient profit level or a stop loss level. In these cases, you cannot use standardized swaps. Instead, a treasurer needs to use OTC (over the counter) products.

Closing a position in fixed-rate IRS by selling the same interest-payment maturities at the new fixed-rate interest rate level reopens the interest position on a variable basis. This means for the treasurer that the IRS long-term position is closed and the underlying asset is refinanced on a variable basis. If both transactions, buying and selling of IRS, are executed with the same bank, the bank exposure is closed and bank limits are no longer blocked. The realized profit or loss is capitalized on a discounted basis and immediately charged to the treasurer's account.

3. The closed position offers two opportunities

• The realized profit or loss will be discounted at the actual interest rate for the remaining period and immediately paid via bank account. Both, purchase and sale of IRS, disappear from the balance sheet of both counterparts. A gain (or loss) appears in the profit and loss account. In case this appears as a one-time profit, it increases the tax payments for the actual year. If transactions are compensated and the interest difference is paid.

• The realized profit or loss will NOT be discounted. All agreed interest payments for both IRS purchase and sale will be made as agreed in the basic contract. This means that profits or losses appear over time at the agreed interest maturity and influence profit and loss only with the portion accruing in the year in which they appear.

Which of the two opportunities to use depends on two factors:

• Do you want to show more or less profit for the actual year?
• Availability of bank limits.

A key point is the average maturity of the underlying long-term investment.

No interest rate risk covering should be made beyond this period as this would amount to pure speculation. Remember, lifetime does not mean how long a machine can work for you. Lifetime includes the period of use after it no longer appears in the balance sheet with a positive amount.

To be on the safe side, all long-term investments should be underpinned by some period-covering credit contract with a bank. These funds should be available for advances on a revolving basis with interest based on 3-6 month short-term rates or fixed rate loans and, very importantly, IRS.

A Fundamental Principle

Speculation and covering of commercial interest rate demand should NOT be mixed, even if your treasury is organized as a profit center.

If your treasury is a profit center, you must ensure that commercial demand and maximization of profit via interest rate instruments have separate cost positions, or better even, a single organization unit, or even better a single subsidiary with its own balance sheet. However, if that's what you do, you may just as well invest in a specialized unit such as a bank.

Long-term experience proves that it's best to invest and work in your company's core competencies. It helps maximize the long-term return on your invested money.