Managing Interest Rate Exposure: Some Simple Tools for Financial Managers

By Forsythe, Dall W. | Government Finance Review, August 1996 | Go to article overview

Managing Interest Rate Exposure: Some Simple Tools for Financial Managers


Forsythe, Dall W., Government Finance Review


A government's exposure to interest rate risk caused by the structures of its assets and liabilities can have significant budget impacts.

In the wake of Orange County's financial meltdown, public-sector financial managers have become much more sensitive to the issue of interest rate risk. One widely understood lesson has been that state and local governments should avoid explicit "bets" on the direction of interest rates which could magnify their interest rate exposure. Financial managers are less likely, however, to recognize exposure to interest rate risk caused by the structure of their assets and liabilities. This structural exposure represents an implicit bet on interest rates and can have significant budgetary impact if not monitored and managed carefully.

Initially, derivative securities were blamed for many of the financial problems suffered by governments after interest rates rose sharply in 1994. More recently, analysts also have begun to assess the interest rate risk of entire investment portfolios. For example, the Government Finance Officers Association (GFOA) recently announced that it intends to develop volatility ratings for government investment portfolios similar to the risk and volatility ratings now used by rating agencies to assess mutual and money market funds.

A government's interest rate exposure does not derive solely from individual securities, however, or even from its entire portfolio of assets. The effects of shifts in interest rates on government financial performance can be analyzed only by understanding how the combined impact of both the asset and liability portfolios produces interest rate exposure. This lesson was learned by banks and their regulators after the savings and loan crisis of the 1980s, and the result has been a developing body of theory and practice under the broad rubric of asset-liability management (ALM). Although these analytic tools have been applied primarily to financial corporations, ALM models also provide important lessons for state and local government financial managers. Several pioneering governments, led by the State of Washington, have implemented asset-liability programs as outlined below. Their experience confirms that the application of even the simplest of those techniques can help state and local financial managers assess and manage their government's interest rate exposure.

Budget Impacts of Interest Rates

Many ALM techniques are designed to measure the impact of interest rate risk on a financial corporation's balance sheet. Although the balance sheets of state and local governments are important elements in the credit-rating equation, operating budget performance is typically the central concern for the day-to-day management of those entities. Thus, in analyzing the impact of interest rates on governments, it makes sense to focus primarily on the budget, not the balance sheet.

Shifts in interest rates affect the budget through two main routes: changes in interest costs paid out in debt service on the spending side and changes in interest income earned on investments on the revenue side. Although most governments budget these two items separately, they can be readily combined to calculate a government's net interest expense, which is simply interest expense less interest income.

Both interest costs and interest income can be further disaggregated into a fixed component and a separate element that is sensitive to changes in interest rates during the fiscal year. On the debt service side, most governments pay fixed interest costs on most of their debt, but also may have notes, commercial paper, or variable-rate debt outstanding. Interest rates paid on notes and variable-rate debt will change during the fiscal year as market interest rates rise and fall, and these expenditures constitute the rate sensitive component of interest costs.

On the asset side, some interest income will come from fixed-rate investments with maturities extending beyond the fiscal year, while the income from shorter term or variable-rate investments will rise or fall as interest rates fluctuate. …

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