In recent years we’ve seen many newspaper headlines reporting the mis-selling of interest rate derivatives and costly derivatives blunders. A key reason for these is that people don’t have a complete understanding of a firm’s interest rate risk and of the risks arising from the use of derivatives.
When encountering interest rate risk at the corporate treasury of firms, at banks, in consulting and in the academic world, I didn’t’ have a comprehensive analytical method that would support the establishment of a sound interest rate risk strategy. On the basis of my Ph.D. research on corporate financial risk management I decided to construct one. My goal was to establish a method that was both academically sound and practical.
The analytical method was used for advising firms on their interest rate risk management strategy. Treasury sales advisors of banks were trained to use the analytical method. These derivatives sales persons already have a lot of experience in this discipline. They were very positive about the analytical method, commenting that it enhanced their understanding of managing interest rate risk from the perspective of the firm and that it gave them a good structure for analysis. The analytical method was formalized, registered as a trademark under the name: The Macrae RISK Reduction Rules and was licensed to third parties.
RISK is an acronym that stands for:
- Risk formulation: The main goal of step 1 is to formulate the risk issue of the firm. The further steps of the analytical method are designed to provide an optimal answer to this risk issue.
- Impact analysis: The main goal of step 2 is to determine the value of risk management.
- Scenario analysis: The main goal of step 3 is to determine in what ways the risk of the firm can be managed, with or without derivatives.
- Knowledge application: The best strategy for risk management is determined from the alternatives provided in step 3. The main goal of step 4 is to formulate an answer to the risk issue defined in step 1.