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Risking your interest.

As risk management continues to envelop more areas, it is good business for the different niches to understand what challenges the others face and what solutions they are using. Such examinations can sometimes lead to adopted innovations and other times simply improve a risk manager's knowledge base.

A sensitive risk management topic for many organizations today is interest rates. Whether a company borrows, lends or invests money, changes in interest rates affect future cash flows. The more long-term transactions completed in a low-interest rate environment, the greater the risk that when rates do rise, a company will need extra cash to stay in business. It will cost more to borrow money and run the company, but customers will continue paying low rates. Thus, the ability to forecast potential interest-rate scenarios and track rate fluctuations helps companies foresee the impact of rate changes on their businesses.

For example, a company might sell outstanding loans made at low rates but keep loans that bear higher rates. Or it might borrow more capital at low rates, anticipating that investments made now will earn more later. Such close attention to interest rate risk can spell the difference between a company that goes bankrupt and one that thrives in a volatile economy.

The Technological Tools

New technology solutions monitor and calculate interest rate risk more accurately, collecting and analyzing key information using thousands of scenarios.

For example, Richard Krakowski's employer, a leasing company, acquired interest rate risk-modeling software in mid-2001. Its aircraft leases generally extend for up to thirty years, so for this portfolio, Krakowski, the chief financial officer, waited to assess interest rate risk on the loans until the portfolio grew to critical mass.

By factoring in the timing of both the incoming and outgoing cash flow and pulling down a forward curve, a consultant, San Francisco-based Aperimus, built an interest-rate risk model that calculates income results on existing business. By examining worst-case scenarios, Krakowski and Louis Lustenberg, the firm's director of pricing, can now determine the aircraft lease portfolio's lowest possible earnings. "It provides us with a better platform to evaluate the expense of the risk, which helps us decide how much [of the portfolio] we want to keep and how much we want to hedge out," says Lustenberg.

"The model will have even greater value as interest rates begin to rise," says Krakowski. "When managing a lease portfolio's interest rate risk exposure, you can't just do it once and walk away. New deals, changes in tax laws and changes in leases require frequent monitoring."

There are also tools for smaller organizations, which may not have the IT systems to support complex modeling programs. For example, Algo Risk, produced by New York's Bloomberg Professional Services and Toronto-based Algorithmics, Inc. is an online tool that determines interest rate and other types of risk.

Monte Carlo models have also seen unprecedented use. These can generate hundreds or thousands of paths that interest rates might follow. They simulate the behavior of a company's balance sheet--product pricing, new business, how many customers prepay their loans--according to each interest rate scenario. The valuation occurs in a risk-neutral world but can be translated to a risk-averse environment.

A change to this implementation of Monte Carlo models is the use of "grid computing," which uses each PC in a network to perform specific calculations. This way, smaller companies can use a network of PCs to do the work of a supercomputer.

More People Getting Involved

The interest rate risk technology market's move down-market exemplifies another trend toward more individuals getting involved with interest rate risk.

"Previously, big banks were the only ones with [risk managers] who understood this stuff cold," says Peter van Amson, vice president of BancWare with SunGard in New York. "Looking at risk from a more complicated, market value perspective is becoming more affordable and more common."
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Title Annotation:interest rate risk technology tools; End Analysis
Author:Hodges, Susan
Publication:Risk Management
Geographic Code:1USA
Date:Oct 1, 2003
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