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‘Investments precede future benefits’. This is common wisdom to most of us. In today’s society many organisations or individuals meet their financing needs by taking a loan or by refinancing old loans. This leads to interest rate risk.
Interest rates and refinancing
Because interest rates can vary substantially, sometimes in unpredictable ways. While the rates have been relatively low up till 2021, we saw interest rates over 10% not so long ago in the 80’s of last century. An organisation with multiple loans with maturities of say 5, 10 or 15 years will be potentially facing higher interest costs by the end of maturity of these loans. Therefore a very important and relevant question to many organisations is:
How can I estimate my future financing costs and what are my interest rate risks?
Aspects in estimating interest risk
- what is the risk-free rate for the maturity of the loan in the region where my organisation is based?
- what is the rating of my organisation, what is the credit spread for that rating and for the maturity of the loan that is to be refinanced?
- What is the potential variation in these two factors
- and, what is a proper methodology to calculate the risks on these two drivers?
Often only banks and insurance companies perform the laborious process and calculations to be able to get a proper estimation of the risks and comply to their regulatory obligations.
However these risks are equally important to any other organisation. We need them to make a betters decisions. For example: to compare the future financing risk against the future cashflows. And to estimate how much buffer one would need to handle these potentially rising costs.
How to estimate the interest rate risk
To illustrate and visualise a few key aspects of this process we have developed the Interest rate risk calculator. This tool shows how the different factors develop over time and what the financial risks are for a certain loan portfolio:
The tool uses the Solvency II methodology which is also applied by insurance companies when managing the market risks of their investments and liabilities. However we do more: where insurance companies look only 1 year ahead, we look multiple years ahead and offer various certainty levels depending on your risk appetite. This enables us to project with a statistical probability of say 80% or 90% what the range is between which the financing costs will move for the next 4 years.
We have applied this methodology for example in the Treasury department of municipalities. Please read more about the risk reports that we create in the Loan Portfolio Risk article.
We also apply other interest rate risk models. For an overview also see our article on the performance of interest rate risk models.
Please feel free tocontact usif you want to receive some more information about our risk reporting services. We would be happy to schedule a video call to show you what such a risk report would contain and how it will help you to get more control over your financial risks.