Interest rate risk affecting fair value

[Porus]

Hi All,

IFRS 7 defines "Interest rate risk" as: "The risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market interest rates."

It is no doubt clear that in the case of variable interest rate loan, the future cashflows will fluctuate due to changes in market interest rates.

However, for a fixed interest rate loan carried at amortised cost, whilst it is clear that future cashflows will NOT fluctuate as a result of changes in market interest rates, would the fair value of the loan change due to changes in market interest rates, such that the profit/loss for the year or equity as at year end would be affected ? Once we arrive at amortised cost using the original effective interest rate, on a fixed interest rate loan, are there circumstances whereby the carrying amount of such a loan would be modified as a result of a change in market interest rates, with the impact going to P&L or direct to equity ?

If there are no such circumstances, why does IFRS 7 include the term "fair value...will fluctuate" in its definition of interest rate risk ?

No doubt, conceptually, if we hold a financial liability at 5% fixed rate, while the market rate for an equivalent liability is 7%, we are in a "gain" situation, while for the same liability, if the market interest rate changes to 3% after a year, we are in a "loss" situation. But this swing in market interest rate from 7% to 3% does not affect our future cash flows since the interest rate is fixed. Does it however affect the carrying value (amortised cost) of the fixed rate loan ? Unless we recalculate a revised amortised cost, based on the latest market rate ? However my reading of IFRS 9 as well as the decision tree in this article https://ifrscommunity.com/knowledge-bas ... erest-rate, appears to indicate that even if the market rate changes, we do NOT revise the amortised cost of the financial instrument.

Thanks

[JakobLavrod]

Excellent question. You have to look at the balance sheet holistically. If you on the asset side have fixed-rate loans, and your liabilities are floating-rate loans, then one way of viewing it is that you have an interest rate risk on the liability side since the interest you have to pay can go up. However, the most common metric to use for measuring the risk is EVE = Economic Value of Equity. To compute this measure, one calculates the effect on Asset - Liability under an interest shock. If market interest rates goes up, that influences the discounting of the fixed rate loans who become less valuable, while the liabilities will approximately retain their value since there rates reset. If both your assets and liabilities are fixed interest, then both will be lowered in the EVE calculation, so they will net each other out.

Hence the point is that even if you hold assets at amortized cost with fixed rate, you can still have an interest rate risk if you have liabilities that have floating rates.

The SVB collapse highlight this problem well. As long as you do not have to sell any assets, and can hold them to maturity, you are correct in that the market interest changes do not have an economic impact, which is why they do not influence the accounting treatment, just as you correctly summaries. The problem comes if you due to liquidity issue need to sell assets that then will have a very market value then the amortized cost, as happened for SVB.

[DJP]

Answering your questions:

"would the fair value of the loan change due to changes in market interest rates, such that the profit/loss for the year or equity as at year end would be affected?" -- no, if the loan is at amortised cost and interest rate is fixed, there will be no impact on P&L/Equity.

"are there circumstances whereby the carrying amount of such a loan would be modified as a result of a change in market interest rates, with the impact going to P&L or direct to equity?" -- only if you are hedging the loan and applying fair value hedge accounting (it would impact P&L)

"why does IFRS 7 include the term "fair value...will fluctuate" in its definition of interest rate risk ?" You do have financial intruments measured at fair value whose fair value will change with changes in interest rates (e.g. derivatives, debt financial assets at FVOCI, some financial assets or financial liabilities designated at FVPL).

Hope this helps clarifying it.

[Porus]

Got it Jakob and DJP, thanks.

Let's say we do not have any FVTPL assets/liabilities, no FVOCI debt financial assets and no derivatives. Only fixed-rate loans (both assets and liabilities) carried at amortised cost.

For disclosure in the financial statements, could one possibly compute a sensitivity disclosure on a given reporting date, even in the case of fixed-rate loans, assuming we had to settle the liability or sell the asset at that date. For this purpose, we would use the current market rate of interest, and thereby recalculate the difference between the amortised cost in the books at a given reporting date, and the revised amortised cost at that date. Is that right ?

So if we were holding a fixed rate financial liability, and the market interest rate decreased, we would get a (theoretical) fair value loss. On the contrary, if we were holding a fixed rate asset, and as above, if the market rate decreased, we would get a (theoretical) fair value gain. So, if we had a net liability position on fixed rate financial instruments, a 1% decrease/increase in market rates, could cause a loss/gain of X amount. Whilst if we had net asset position on fixed rate financial instruments, a 1% decrease/increase in market rates, could cause a gain/loss of X amount.

Albeit, I have not seen such disclosures in non-FSI financial statements re: fixed interest rate sensitivity analysis. Seen only floating rate sensitivity analysis.

[DJP]

"and thereby recalculate the difference between the amortised cost in the books at a given reporting date, and the revised amortised cost at that date. Is that right ?"

No, if you only have fixed-rate instruments accounted for at amortised cost, your P&L/Equity does not get affected by changes in interest rates.

[Marek Muc]

"would the fair value of the loan change due to changes in market interest rates, such that the profit/loss for the year or equity as at year end would be affected?" -- no, if the loan is at amortised cost and interest rate is fixed, there will be no impact on P&L/Equity.

different perspective on this one from me:

YES - but another question is whether this change in fair value will be recognised. For example, fair value of all financial instruments needs to be disclosed and compared with carrying amount under IFRS 7.25-29

[DJP]

Yes Marek, you are right. Changes in interest rate will have an impact on fixed instruments at amortised cost for fair value disclosure purposes.

I simply assumed that the question was asked in regard to sensitivity analysis disclosures.

[Porus]

Gentlemen,

Read through all your comments/clarifications, thanks. Noted that fair value disclosure is required under IFRS 7.25-29. However, isn't sensitivity analysis disclosure just one step further, once you calculate the fair value of a fixed rate financial instrument - eg. "if the market interest rate changes by 1%, the FV will increase/decrease by $ xxxx" ?

This is ofcourse under the implicit assumption that there would be a need to settle the financial liability or dispose off the financial asset instead of holding it to maturity, otherwise fair value would be irrelevant in the case of a fixed rate financial instrument.

[Marek Muc]

I simply assumed that the question was asked in regard to sensitivity analysis disclosures.

And I assumed that this was purely theoretical dispute