Common corporate interest rate risk management practice is embodied in policy stating that the fixed-floating mix should vary within some pre-defined range.

Even if this range is not explicitly defined in policy, most corporate treasurers will have identified a target fixed-floating mix with which their board is comfortable, and will actively manage the fixed-floating mix in line with this mark. Targeting this range through managing debt issuance alone may prove difficult and so there is a place for derivatives in managing the fixed-floating mix in this respect. The mix could be managed actively within the target range, or adjustments can be made reactively using derivatives when the underlying debt profile reaches the bounds of the range. Tactical decisions to adjust the fixed-floating mix within the policy bands can be actively implemented within a reasoned and structured framework. The framework discussed here is customisable and can be specified to suit all, from the least to the most sophisticated of corporate treasury functions. Following the approach for tactical decision making can achieve a positive corporate earnings impact. In addition, having a clearly defined and defendable approach to tactical positioning will help to provide confidence to the corporation’s board, and stake holders, that the tactical positioning activities are not purely speculative.

Fixed-floating bands

A common corporate interest rate risk management policy approach is for the corporation to target a fixed-floating mix between lower and upper thresholds. There are a number of reasons for the range of permitted deviation; three of these are pragmatism, uncertainty and flexibility.
Pragmatism lies in the fact that the fixed-floating mix of net debt can change quite rapidly with amortisation of existing liabilities and changes in the amount of cash on the balance sheet. Thus without constant treasury intervention, a fixed-floating range gives the treasury the ability to manage the interest rate position from a macro perspective. Uncertainty in what the corporation should be targeting as a fixed-floating mix might lead the corporation to define a range for the policy, lest it be put in a position of having to explain the choice of a single fixed-floating mix target if questioned. Finally, flexibility may be given to the treasury to adjust the fixed-floating mix within the band to express a view on whether it should be more fixed or more floating than the norm, given the corporation’s current financial standing. A view may also be expressed by the treasury about being more fixed or floating than the norm given the current yield curve shape and the current point in the interest rate and economic cycle.

A strategic view versus tactical positioning

It is worth mentioning that although focusing on the tactical side of interest rate risk management here, it is important that tactical decisions are made within the context of a strategic plan. Corporations with a fixed-floating range or target mix should view this, in the long term, as being the most appropriate fixed-floating mix for the corporation across the interest rate cycle.

The band, or perhaps the mid-point of the band, can be viewed as the benchmark fixed-floating mix which is optimal for the corporation. Typically the benchmark would be the most appropriate mix given the interest rate risk profile of the business; taking into account all those elements of the corporate risk profile which are sensitive to interest rates and impact corporate performance. Elements such as corporate debt, cash, cyclical business cash flows, pension assets and liabilities all may be considered. Around the benchmark mix, there may be times within the cycle when it is deemed advantageous to be more fixed or more floating. A method of deriving and implementing a framework that provides the corporate treasury a set of rules which dictate when to be overly fixed or floating is discussed below.

Building a framework for tactical interest rate risk management

The following four step methodology highlights the key considerations which need to be evaluated in setting up a formal tactical interest rate risk management policy. The steps set out the method by which performance is measured, how the interest rate profile is varied and how to validate the benefit of the tactical policy through historical back testing.

1.    Performance measure
    The primary rationale for the tactical policy is that it should benefit the corporation, in terms of reducing the companies exposure to risk, and by lowering the interest cost of the liability portfolio. As such it is fundamental that the policy’s performance should be measurable, but how should performance be measured?
    A typical corporate treasury may be set a budget interest rate, or cost of funding, for the current budget period. However, measuring performance relative to a budget rate will not give an unbiased reflection on the performance of the tactical strategy. What is more appropriate is to measure performance of the tactical strategy relative to a passive benchmark strategy. Thus the benefits of decisions to adjust the interest rate profile on a pro-active basis can be measured against a “do nothing” benchmark approach.
    Relative performance measures can focus on outright cost savings of active versus passive strategies. More sophisticated measures may incorporate a risk-adjusted cost savings measure to capture any overstatement of cost savings which are achieved at the expense of taking on disproportionate amounts of risk.
2.    Variation mechanism
    The mechanism of variation defines how the interest rate profile of the company will change in terms of how changes are expressed and implemented. Is the mechanism to vary the fixed-floating mix? Or is it the duration or maturity profile of liabilities? Does the variation method involve entering into linear instruments (FRAs, futures, swaps) or options (caps, floors, collars, swaptions) or structures products?
3.    Decision parameters
    The most critical step in the methodology which provides the most scope for flexibility and complexity is setting out the tactical decision parameters which define when adjustments to the interest rate risk profile occur.
    Decision parameters could take the form of market signals based on levels of interest rates, inflation or economic growth indicators. Using market indicators to dictate investment strategy is common place amongst asset managers who use signals to decide when to buy or sell particular types of assets in the market. Although not traditionally used in the corporate risk management space, market signals can be built to indicate to liability managers when to be, for example, overly fixed or floating relative to a benchmark level.
    The flexibility and complexity of the strategy will be derived from the signals that are used in the strategy and how profile variations are set out. Defining what makes an appropriate signal is the trickiest task as it is somewhat akin to identifying a method for beating the market. It involves identifying a pattern between interest rates, inflation and economic growth indicators and the subsequent behaviour of the yield curve and fixed-floating debt cost. Further decision parameters which need to be set are the variation decision frequency, setting out how often the signals monitored; the minimum/maximum trade close out period and any other associated trading restrictions.
4.    Strategy performance validation
    The benefit of the tactical strategy, relative to a benchmark, can be validated by performing a back test using historical data. To be viewed as a good strategy, the market indicators should be frequent enough to have given a significant number of variation signals. A strategy which historically gave few variation signals might lead to a strategy which does not deviate from the benchmark with any regularity going forward.
    The other key validation is to identify a successful strategy. Here an out-right profitability measure (total return/interest cost savings) may be the primary focus but other measures such as success rate may also be important.

An example strategy

1.    Performance measure
•    Interest cost of gross debt portfolio (€1bn portfolio)
•    Include interest cost from debt + total return from hedges
•    Measure interest cost performance of tactical strategy relative to a benchmark liability profile with a 50:50 fixed–floating mix
2.    Variation mechanism
•    Adjust the fixed floating mix using vanilla interest rate swaps
3.    Decision parameters
•    Decisions based on the level of floating rates and the term premium (spread between floating and fixed rates)
•    Floating rate indicator based off current level being outside the previous 6 months 65th and 35th percentile range
•    Term premium indicator based off current level being above or below previous 36 month moving average

•    Strategy moves to a 30% fixed percentage if floating rates are bellow 35th percentile and the term premium is below the moving average. Strategy moves to a 30% floating percentage if floating rates are above the 65th percentile and the term premium is above the moving average. A 60% fixed percentage is put in place if floating rates are between the 35th and 65th percentile and the term premium is below the moving average and a 60% floating percentage is put in place if the term premium is above the moving average. A 50:50 fixed floating mix is maintained otherwise
•    The tactical positioning strategy is re-evaluated each month
4.    Strategy performance validation
•    Back testing period: November 1992 – April 2006

Over the back testing period, the tactical strategy outperformed the benchmark with 68% success ratio. The average cost savings of the tactical strategy relative to the benchmark 50:50 fixed-floating strategy amounted to an average of 8.3 basis points; 14.4 basis points if scaled by the number of periods when deviating from the benchmark strategy.

Although, or course, there are no guarantees that the strategy will perform in the same manner in the future, if grounded in economic sense, a historical analysis which validates the strategy should give some comfort to the corporate risk manager the approach is well founded and creates the most appropriate basis for making tactical decisions.