Interest risk or interest opportunity?

Derivatives. This word has become synonymous to all that is wrong in the financial world. But it was not the derivatives that were to blame; it was the banks that enabled their incorrect use. How can derivatives manage your risks in a good way?

Derivatives

Derivatives. This word has become synonymous to all that is wrong in the financial world. But it was not the derivatives that were to blame; it was the banks that enabled their incorrect use. How can derivatives manage your risks in a good way?
Interest risk management is a subject many businesses have little or no experience with, something that only large business are involved with. But each business, also SME businesses, is affected by interest rate movements, even an interest increase of as little as a half percent can lead to a significant financial burden. Risk is only discussed when the financing has already been arranged or when the interest review date comes up. In that case, you hope the interest will not have risen too much. The same goes for foreign currency. A company that sells machines overseas and is paid after shipping can run into serious trouble if the exchange rate of the dollar has lowered between the price agreement and the time the machine is delivered.

Influencing costs and profitability

In order to hedge risks in exchange rate and interest differences, business can use derivatives. For interest, this often involves financing for long-term investments, e.g. real estate. For foreign currency, it often involves the day-to-day business. Derivatives are a tool that manages a risk that the business has no control over, but can seriously impact cost and profitability. This only works if the derivatives are used correctly. For example, the main sum of the risk that needs to be hedged cannot exceed the reasonably expected underlying investments.

Interest cap: easy instrument

Two types of interest derivatives are the interest cap and the interest swap. The interest cap is a type of insurance whereby the business pays a premium without any further obligations. When an interest cap on 3 percent is acquired, the limit for the underlying variable Euribor interest remains 3 percent. Should the Euribor interest rise to 4 percent, then the bank will repay 1 percent. If the Euribor interest is 1 percent, then the business will naturally pay 1 percent. Roel van Bezooijen, Senior manager treasury at Baker Tilly feels that banks do not often advise the interest cap. “It is a wonderful and easy instrument and is relatively cheap. The premium could put businesses off, but the premiums are already covered in other products. No product is ever for free.”

Interest swap: understanding the construction

The interest cap has been given less attention than the interest swap. In a swap, the business exchanges the variable Euribor interest with the bank at a fixed interest rate with a fixed duration. In principle the interest swap is a good product. Still, it was the interest swap that caused the most problems. Many interest derivatives were taken out before 2008, when the interest was approximately 4 to 5 percent. The current lower market value results in a lower market value of the interest swap, and a negative market value. If the interest swap is 5 percent and the underlying market interest is 1 percent, then you will need to pay if you wish to lose your product. This results in products having a negative market value. This is not a problem, as long as cost price hedge accounting is applied. This is a model of hedge accounting whereby the hedge instrument (the derivative) as the hedged position is valued at cost price. This will stop the negative cost item from included in the profit and loss account.

Holding on until the expiry date

Many businesses are ill informed of the disadvantages of these constructions – or claim they have been ill informed. The negative reporting has meant that they would rather avoid the interest swap. On the other hand, it is true to say that high interest rates also applied to the alternative to an interest swap, a fixed-interest loan, some five years ago. These also had to be paid before the due date. Moreover, most businesses hold on to the interest swap up until the expiration date. Van Bezooijen: “Each derivative, including the swap, has a value of zero at the end of the journey. It is true that a swap can, in the mean time, have a negative market value, but that is only on paper as you are not planning to sell it. It is comparable to having a negative equity on your house at a time you are not intending to move.”

Alternative solutions

Nevertheless, the word derivatives has almost become synonymous to all that is wrong in the financial world. But the derivatives themselves are not bad. The banks have enabled derivatives to be used incorrectly. “The banks also failed to inform businesses of the alternative solutions available to them, such as the more favourable interest cap or the splitting of one loan into a fixed-interest loan and a variable loan. “This involves more administrative work for the bank. Banks prefer offering clients a fixed-interest or a variable interest loan, but they will seldom offer a mix of the two.”

Expectations and appetite for risk

The use of derivatives can only be successful for a business, if they are used with its vision in mind. “The business knows the expected turnover, liquidity, risks and competition. You then look what to the maximum costs he can and wants to have.” Which product is right for a business depends on what the expectations of the business are and what risks it is willing to take. For example, can he handle a slight interest rate increase or not. “Once you have determined this, you can include the bank’s vision and expectations, which should never be leading in the choice of a product.”

Prepared and ready to go

Upon entering into a financing agreement, a business must determine how they can best manage and limit their interest risk. He can ask an independent advisor to provide an overview of the possibilities, draw up a scenario analysis and assess the bank’s quote to determine the cost and reasonable margin. After which the negotiations are held and the business chooses the product and closes the transaction. An advisor can also make an assessment of the existing derivatives on how they were created, their historical value and how much the bank earns on them. When this raises questions on the bank’s duty of care, the business – besides legal steps – can appeal to the bank’s moral duty in order to receive some form of compensation.

Developments derivatives

Derivatives will always be around. Due to, for example, the increased insecurity of the interest developments, the interest risks becoming increasingly important. Even so this is less than before due to the bad reputation of interest derivatives and, more importantly, the strong decline in the number of financing transactions. The foreign exchange risks are now more relevant, as business are operating at an increasingly international level. Currency fluctuations are occurring more frequently due to the speed of information. They have also become more difficult to predict because they respond to rumours rather than fact. 

Raw materials derivatives are also rapidly developing products. The increasingly varying prices of raw materials could also have an effect on the products of a business. It is expected that banks will focus more and more on foreign exchange and raw materials derivatives.

For more information, please contact our Corporate Finance advisors.