Interest rate risk in treasury management represents the risks that could arise from changes in market interest rates on a company’s finances. For example, if a company has $50 million in floatingrate borrowings with an annual rate of 3% and the rate increases to 4%, the company’s interest expense will jump by $500,000 (1% × $50 million) per year. The company can use an interest rate swap to convert floating rates to fixed rates, locking in financing costs and reducing fluctuations. For example, the company may agree to an interest rate swap that fixes the payment on its floatingrate loan at 3.5%, avoiding any future rate increases.
Definition of Interest Rate Risk
Interest rate risk describes the negative consequences that can impact a company’s finances and cash flow if interest rates move less favorably than assumed in its treasury policy. Interest rate risk includes changes in interest payments, financial stability, and investment returns due to fluctuations in market borrowing costs. If market rates increase, the company will have to pay higher interest expenses, leading to increased financial costs and potential profit compression.
Types of Interest Rate Risk
Interest Rate Level Risk
Interest rate level risk refers to changes in a company’s financial status due to generalized increases or decreases in market interest rates. For instance, if a company borrows $10 million at a floating rate of 3% in 2023 and the market rate rises to 4% the following year, its borrowing costs will increase by $100,000 ($10 million × (4% – 3%)). With substantial debt, the company might become unprofitable once the change takes effect. One large multinational reported in its latest financial statements that the cost of their floatingrate loans increased by 15% as market rates rose, affecting annual earnings by about 10%.
Interest Rate Term Structure Risk
Interest rate term structure risk occurs when changes between shortterm and longterm interest rates affect a company. If shortterm rates rise while longterm rates remain unchanged, the company may face higher costs for shortterm financing. For example, if a company borrows $10 million at a shortterm rate of 2% in 2023 and rates rise to 3% the following year, its interest costs will increase significantly. If the longterm debt interest rate is only 2.5%, the increase in shortterm borrowing costs will be substantial relative to overall financing costs, necessitating a risk management strategy focused on treasury spreads.
Market Data and Trends
Global central banks have generally raised rates. In Q1 2024, the Federal Reserve raised rates four times in 2023, by a total of 1%, each time increasing the main policy rate by 25 basis points. This led to a shortterm rate rising by approximately 25% in Q1 2024 compared to the beginning of 2023, from low to midsingle digits (closer to <5%). In 2023, the European Central Bank also raised rates three times by a total of 75 basis points. These rate changes mean companies need to consider increased interest costs and reevaluate their financial strategies.
Risk Management Strategies
Companies can handle interest rate risk in several ways:

Interest Rate Hedging Tools: Examples include interest rate swaps and options. Through an interest rate swap agreement, a company can convert its floatingrate debt into fixed rates, locking in financing costs. For instance, a company that converts $30 million of floatingrate debt to a fixed rate will maintain stable interest costs even if market rates rise.

AssetLiability Structure Adjustment: Restructuring liabilities, such as converting shortterm debt to longterm debt, can help manage the impact of rate changes. If shortterm debt constitutes 60% of a company’s total liabilities, it could consider converting some into longterm debt to reduce sensitivity to shifts in shortterm rates.

Treasury Management Optimization: Optimizing the use of funds, reducing external financing, and increasing internal reserves can cushion the impact of rate fluctuations.