| Broad range of sophisticated products on offer for treasurers |
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By: Criona Fitzgerald, Criona Fitzgerald
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| The days of treasurers using just plain vanilla hedging strategies are long gone. Criona Fitzgerald looks at the increasing range of sophisticated products on offer aimed at reducing corporates’ exposure to interest rate movements, including knock-out swaps and extendible swaps. |
Over the last twelve months, interest rate movements have largely dominated the markets. In December 2005, the European Central Bank embarked on a series of interest rate hikes, moving rates from historically low levels of 2.00 per cent to current levels of 3.50 per cent. The US and UK also increased rates to 5.25 per cent and 5.00 per cent respectively. Due to these aggressive rate movements, a close relationship between banker and treasurer would have been critical in the successful management of a companies interest rate risk. In a rising rate environment, borrowers will be concerned that rates rise above their level of expectations and as such will want their exposures protected.
Traditionally, treasurers used plain vanilla products to hedge interest rate exposures. Over the years, more sophisticated products have been developed and nowadays there is certainly plenty of choice for treasurers who wish to explore alternative hedging solutions. Treasurers are seeking more innovative solutions from their banks and the growth in this market is evidence of the demand. | | Criona Fitzgerald |
As part of an international bank, we have access to a broad range of products and can offer our customers solutions that allow them to manage their interest rate risk in innovative ways. The plain vanilla products are still popular, offering certainty and simplicity, without upfront premiums, however, these may not be flexible enough for a treasurers requirements. Customers want to benefit from favourable rate moves, while having some level of protection and flexibility. It is important to listen to customers, introduce and present tailored solutions, which allow flexibility, at competitive prices.
When businesses look at interest rate risk management and appropriate solutions they need to first decide on the appropriate time horizon and focus on average rate implications. The average cost of funds achieved by a business over a period is more important than a specific level at any point. In addition, a favourable funding requirement for treasurers will reduce risk and boost return.
In the past, the alternatives for a treasurer were fairly simple - remain on a variable rate (no protection), book a fixed rate (which gives total protection and certainty but with potential opportunity cost), or hedge using an interest rate cap or a zero cost collar. Of course, the type of product chosen will largely depend on the company policy on interest rate risk and the strategy taken to combat this risk.
Treasurers don’t need to use complicated new products but there may be some benefits to looking at the different products available to make an appropriate decision. It is vital for the banker to know from the beginning what the company wants and needs, the company’s strategy and policy, and work from there to tailor and achieve a suitable solution.
Obviously market expectations are of utmost importance when a treasurer is considering hedging interest rate risk. So, where next for eurozone interest rates? The European central bank has taken steps to combat fears of emerging inflation by raising interest rates to 3.50 per cent over the last year. Inflation in the eurozone is currently running at around 1.8 per cent and we are concerned that the German VAT hike will have a significant effect on growth and that the US will not rebound as some Fed members are assuming. The risk is of course that growth everywhere remains strong and that the ECB keeps tightening policy. There appears to be a hawkish faction on the ECB Governing Council (e.g. Weber, Wellink) who will continue to argue for higher rates next year but the majority are happy to wait and see. So in short, be on the lookout for robust data and the ECB’s comments for indications on the future direction of interest rates.
In a rising rate environment, the cost of fixing in earlier years is higher, so many treasurers are reluctant to lock in to fixed rates as they lose the benefit of low variable interest rates. This is known as the carry cost of fixing (differential between Euribor and the swap rate). Looking at the alternative hedging strategies available, there is still value to be got from paying fixed even though rates have risen, given that the curve is now flat and the cost of carry is now minimal.
The following products would suit a customer who wants to hedge their exposure and take advantage of the flat curve and positive carry.
This trade is suitable for a customer who wants to pay a relatively low fixed rate, while taking advantage of the flat swap curve, thus minimising the cost of carry. The customer will pay a fixed rate for a specified number of years as long as 3 month Euribor is below a certain knock out cap level.
Taking a seven year hedge as an example, a fixed rate of 3.43 per cent for 7 years is payable as long as the 3m Euribor is below a knockout level of 4.30 per cent. For comparison purposes, the current 7 year fix is at approximately 3.85 per cent. If 3m Euribor is greater than 4.30 per cent, then the customer pays 3m Euribor (currently 3.63 per cent). The advantage is the customer can potentially fix at 42bp below current market levels. So, the customer will benefit if 3m Euribor stays below 4.30 per cent for the next 7 years.
This trade works well if the customer wants to pay a low fixed rate but is indifferent to the maturity date. The risk here is that no cashflows occur if the 3m Euribor is greater than the knock out rate, so the customer retains floating rate risk. Historical data shows that Euribor has been below the knockout rate of 4.30 per cent for the last 5 years. Also, there is room for unexpected rate rises, as the knockout rate for this trade is set above the forward curve.
This type of trade would suit a customer who wants to pay a low fixed rate, is flexible with the fixing maturity, is indifferent to either continue paying the fixed rate or switch to Euribor in later years and wants to take advantage of the flat swap curve to achieve a positive carry. The customer pays a fixed rate for a specified number of years, and potentially for the full term. After the guaranteed term, the bank reserves the right to extend the swap for the full term. The risk is that the customer will benefit from fixing at a lower rate for the guaranteed maturity but the bank may not extend the deal after the minimum period.
Looking at a five year hedge as an example, the customer agrees to pay 3.38 per cent for at least one year. After one year, the bank retains the right to extend the swap for another four years. When compared against current 5 year fixed rates @ 3.84 per cent, the customer potentially saves 46bps. So, the customer benefits from a low cost fixing for a guaranteed maturity, with potential to extend this for a further 4 years.
To conclude, in forging close relationships with customers, listening to their wants and needs, we can provide innovative, tailor-made solutions and deliver a product, which is the best, and most appropriate risk management strategy. |
Criona Fitzgerald works in corporate treasury in Investec Bank.
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