Putting a Figure on it – Examining the Profitability of Interest Risk Management

In another post, we examined the profitability of Cash Pooling and how this can be quantified. Today, we'd like to focus on another risk management discipline: active interest management. Based on specific calculations, we will illustrate how and to what extent active interest management can also boost corporate profitability.

Last time, we introduced Supplier plc., a globally active group with FX flows and international payments. Today’s analysis will again be based on this realistic, yet fictitious group whose financial profile can be summed up as follows:

• Turnover: EUR 1.5 billion
• EBIT: EUR 70 million
• EBT: EUR 50 million
• Borrowed capital: EUR 500 million
  Of which long-term borrowed capital: EUR 200 million
  Of which short-term borrowed capital: EUR 80 million
• Equity:  EUR 300 million
• Liquid assets: EUR 30 million
• 20 offices in 10 different countries
• 5 different currency areas: Euro (EUR 50%), US Dollar (USD 20%), Pound sterling (GBP 10%), Japanese Yen (JPY 10%), Swiss Franc (CHF 10%)
• Average borrowing rate: 4.0 %
• Average investment rate: 0.5 %
• Average gross payment volume (incoming and outgoing) per year: EUR 1.5 billion
• Gross intercompany payment volume per year: EUR 0.75 billion
• Number of intercompany payments per year: 120,000
• Number of group-wide bank accounts: 80 (an average of 8 per group entity)
• Cash pools: 1 EUR zero-balancing cash pool, pooling the EUR entities

In light of iterest rate fluctuations, Supplier plc. hedges corresponding risks with derivatives, mainly interest rate swaps. The most simple form of an interest rate swap is a fixed-to-floating swap. For example, a company pays a fixed interest rate to a bank in exchange for floating-rate payments, effectively eliminating exposure to fluctuations in interest rates. The floating leg is usually based on a reference rate, such as EURIBOR, plus a fixed amount, known as the spread. The spread depends on the credit rating of the parties involved in the swap and the default probability. Another determining factor for the spread is the interest rate swap’s lifetime, i.e. the default probability for a 5-year swap is higher than for a one-year deal. This means that the spread for deals with a longer lifetime is higher.

The following example is meant to illustrate the value contribution of an interest rate swap. We stated earlier that Supplier plc.’s long-term borrowed capital amounts to EUR 200 million: they have taken out a floating rate bank loan tied to the 3-month EURIBOR plus a margin of 350 basis points. The loan is a bullet loan with a three year term and yearly interest rate payments. Supplier plc. enters into a payer swap contract to hedge this floating rate loan against interest rate increases. The swap contract stipulates fixed-rate payments in exchange for floating-rate payments. The fixed interest rate is 4.0 percent and the floating rate is tied to the 3-month EURIBOR, including a margin of 350 basis points. The amortization schedule, the principal and the lifetime correspond to those of the bank loan. Supplier plc. is anticipating interest rates to rise but has secured a fixed interest rate for the entire term. This interest rate swap allows them to eliminate the risk of increased interest rates, as floating-rate payments are hedged by the swap. For simplication purposes, we will assume a positive 3-month EURIBOR of 0.5 percent when the loan is taken out.

The example illustrates that a payer swap pays off in a rising interest rate environment, as Supplier plc. is hedged against higher interest payments in years 2 and 3. Based on the historical development of the 3-month EURIBOR, a 1.5 percent increase in interest rates over 2 years is definitely a realistic scenario. Overall, Supplier plc. is able to reduce interest expense by EUR 4.5 million by entering into a swap contract.

We previously set the initial overall corporate profitability of Supplier plc. at 8.75 %. Taking into account the above table’s figures in connection with an interest rate swap, and further assuming rising interest rates, results in the following scenario:

“Corporate profitability = ”  “EUR 54.5 million + EUR 20.0 million” /”EUR 300 million + EUR 500 million”  ” * 100 % = 9.31%”

Despite increasing interest rates, Supplier plc. is able to maintain their interest payments at a constant level by entering into a swap contract. Over the course of three years this allows them to save EUR 4.5 million in interest payments. In turn, this has a positive impact on corporate profitability which can be boosted by 0.56 %. In terms of an annual average, this corresponds to a positive value contribution of EUR 1.50 million and an increased corporate profitability of approx. 0.19 %.

We’ve seen that treasury activities in connection with both currency risk management and interest risk management can be quantified and boost corporate profitability.

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