Don’t shoot the messenger

We are only a week or so past 30 June (a common balance date for many Hedgebook clients) and already we are fielding questions/comments regarding the big movements in the mark-to-market valuations of our clients’ portfolios. The questions have nothing to do with the accuracy of the valuations but mostly around, “why has this happened?” Many of the big movements relate to our clients that hedge their interest rate risk via interest rate swaps.

It is no surprise given the sharp downward movements we have seen in the New Zealand and Australian yield curves over the last few months (see charts). A 1% move on a 5 year $5 million swap will result in a $250,000 move in the mark-to-market. Depending on the size of your swap portfolio, and the tenor of the swaps, the moves can be material.

NZD swap movements

AUD swap movements

An interest rate swap is a valuable hedging tool which helps companies manage their interest rate risk. Many companies have treasury policies which force them to have a proportion of fixed and floating interest rate risk which helps with certainty of interest cost as well as smoothing sharp interest rate movements, both up and down. However, there is also a requirement to mark-to-market swaps, and for many to post these changes to their profit and loss account. Some companies negate this profit and loss volatility by hedge accounting, but many don’t which often requires some explanation to senior management, directors and investors.

For publicly listed companies the impact, both real and perceived, of large movements in financial instrument valuations is even more critical. The requirement for continuous disclosure means that a large move in these valuations may require the issue of a profit warning, as we have recently seen from Team Talk, the telecommunications company. Team Talk’s shares dropped 6.3% on the back of the hit taken by a revaluation of interest rate swaps. The company noted that the change in the value of the interest rate swap portfolio was due to “wholesale interest rates falling significantly in the period”.

Equally we have a number of private companies and local governments who have been concerned at the change in their valuations and how they are going to be explained further up the tree. Having constant visibility over these changes will at least forearm any difficult conversations, as opposed to relying on the bank’s month end valuations.

Whilst Hedgebook won’t help improve mark-to-market valuations, it does assist with companies keeping abreast of changes in the value of swap portfolios on any given day. This is pretty much a “must have” for publicly listed companies that have the responsibility of continuous disclosure but forewarned is forearmed and many others are also seeing the benefit of having access to mark-to-market valuations at any time.

Mis-selling of swaps case dismissed

Further to our article posted last week, there has been more evidence to confirm that borrowers crying about “mis-selling” of swaps is not going to garner sympathy in the courts. A sophisticated borrower, or an entity with access to expert advice, cannot lay blame at the door of the banks for their own misjudgments for what have been in hindsight poor hedging decisions.

Hedging, and a deeper look into the types of Financial Hedges

One of the popular misnomers about hedging is that it is a costly, time-consuming, complicated process. This is not true!

At the end of the day, there are two different types of hedges: natural hedging and financial hedging. It is not uncommon for companies to use one or both methods to implement their hedging strategies in order to protect their bottom line from currency risk.

Natural hedging involves reducing the difference between receipts and payments in the foreign currency. For example, a New Zealand firm exports to Australia and forecasts that it will receive A$10 million over the next year. Over this period, it expects to make several payments totaling A$3 million; the New Zealand firm’s expected exposure to the Australian Dollar is A$7 million. By implementing natural hedging techniques, the New Zealand firm borrows A$3 million, while subsequently increasing acquisition of materials from Australian suppliers by A$3 million. Now, the New Zealand firm’s exposure is only A$1 million. If the New Zealand firm wanted to eliminate nearly all transaction costs, it could open up production in Australia entirely.

Financial hedging involves buying and selling foreign exchange instruments that are dealt by banks and foreign exchange brokers. There are three common types of instruments used: forward contracts, currency options, and currency swaps.

Forward contracts allow firms to set the exchange rate at which it will buy or sell a specified amount of foreign currency in the future. For example, if a New Zealand firm expects to receive A$1 million in excess of what it forecasts to spend every quarter, it can enter a forward contract to sell these Australian Dollars, at a predetermined rate, every three-months. By offsetting the A$1 million with forward contracts every month, nearly all transaction costs are eliminated.

Currency options tend to be favorable for those firms without solidified plans, i.e., a company that is bidding on a contract. Currency options give a company the right, but not the obligation, to buy or sell currency in the future at a specified exchange rate and date. Upfront costs are common with currency options, which can deter small- and medium-sized firms, but the costs are for good reason: currency options allow firms to benefit from favorable exchange rate movement. Like interest rate swaps, whose lives can range from 2-years to beyond 10-years, currency swaps are a long-term hedging technique against interest rate risk, but unlike interest rate swaps, currency swaps also manage risk borne from exchange rate fluctuations.

Exchange rate volatility can affect a company’s hedging strategy – the next post will cover why timing is key.

Hedging Basics: Hedging Using Interest Rate Futures Risk Reversals

Exposure to the interest rate markets can be hedged with many financial instruments. One of the more flexible is the risk reversal.  A key benefit of the risk reversal is that it does not exposure the hedger to immediate gains or losses (similar to a swap or futures contract) as it allows the hedger to create a range in which their exposure is un-hedged.

Futures Contracts
A futures contract is an obligation between two parties to purchase or sell a physical or financial product as some date in the future.  Interest rate futures are traded on exchanges such as the Chicago Mercantile Exchange and provide a clearing platform for traders that eliminate credit risk.

The strategy of a risk reversal for a hedger that is looking to mitigate downside exposure to the interest rate market is to purchase a put on an interest rate futures contract and simultaneously sell a call on an interest rate futures contract.  The strike price of the call and the put are generally a certain percentage away from the current spot price, creating a range above and below the current price where the trader is not hedged.  If the price of the futures contract falls below the put, the trader receives a payout.  If the price of the futures contract rises above the call, the trader needs to make a payment.

Hedging Basics: Swaptions

Interest rate options are excellent tools to use to mitigate interest rate exposure.  One robust structure that is used to reduce exposure to monthly periods of interest rate volatility is the interest rate swaption.  This instrument combines the protection of a swap, with the flexibility of a European style option.

Interest Rate Swap
An interest rate swap is a fixed for floating swap which allows an investor or corporate treasurer to reduce their exposure to interest rates by selling or buying a swap.  A pay fixed swap reduces exposure to climbing interest rates while a pay float swap reduces exposure to declining interest rates.

European Option
A European style option is an option in which the purchaser of the option can only exercise the option on the expiration date.  The option is the right but not the obligation to purchase a financial instrument as a specific date in the future.  The strike price is the price at which the buyer and seller of the option agree to buy/sell the financial product.

Interest Rate Swaption
An interest rate Swaption is the right but not the obligation to purchase an interest rate swap on a specific date.  On the expiration date, the owner of the swaption has the right to purchase the swap at the strike price.  A swaption payout profile is similar to a European option.

Hedging Basics: Currency Swaps

A currency swap locks in a price of a currency pair and is another tool that can be used to manage an organisation’s cash flow. The currency swap pays the fixed-price buyer of a currency pair a payout equal to the difference between the current price and the settlement price of the swap.

Fixed for Float Swap
A (fixed for floating) swap is a financial product which acts as a hedge against an adverse downside movement for an investor or corporate hedger.  The components of a swap are as follows:

  • Reference Index:  A pricing index such as a currency pair future or OTC currency pair
  • Fixed Price is a negotiated price which will be compared to the floating (index) price to determine if the swap is in our out of the money.
  • Floating Price is created from the reference index by averaging the reference prices over the period of the agreed swap.
  • Floating Payment is calculated by multiplying the floating price by the volume of the notional used for the currency pair.

Swap Calculation: The average floating price over the swap period is compared to the fixed price, to determine which way cash will flow.

Swap Pricing Periods: The periods of time that are agreed upon which incorporate the swap.  When the swap period is complete the floating price is examined, and payments are exchanged. Generally monthly periods are used to compute swaps.

The Euro-zone Crisis: Goldman Sachs, Greece, and Swaps

This is part 8 of a 10 part series on currency swaps and interest rate swaps and their role in the global economy. In parts 1 through 4, we discussed the differences between interest rate swaps and currency swaps, as well as the pricing mechanisms for fixed-for-floating, floating-for-floating, and fixed-for-fixed swaps. In part 8, we’ll discuss the role of swaps in more recent times: the Euro-zone crisis.

In June 2001, seeking to shore up its finances as it prepared to use the Euro as a member of the Euro-zone currency union, Greece reached a deal with the U.S. bank Goldman Sachs to borrow €2.8 billion.  When the deal was reached, the Greek government had already owed Goldman Sachs about €600 million – not counting the €2.8 it just borrowed.

Just four years later, the costly transaction nearly doubled to €5.1 billion. It turns out that a currency swap agreement was in place to help conceal Greece’s haphazardly constructed balance sheet, which showed that the country was experiencing an unsustainable rise in its debt-to-GDP ratio. Without the deal, Greece wouldn’t have been able to join the Euro-zone, as its debt-to-GDP ratio was in breach of the European Union’s rules for the amount of debt each country could have in order to join the Euro. But a loophole in the law allowed the currency swap agreement in place to not be counted as debt, thereby keeping Greece’s debt-to-GDP ratio within the European Union’s required range.

The arrangement made in June 2011 had two key components. The first was a series of currency swaps. Greece’s debt, which historically was accounted for in Japanese Yen and U.S. Dollars, was converted to Euros for the transition into the common market. Instead of the contracts being transacted at the spot exchange rate, they were measured against a fake exchange rate devised by the Greek government and Goldman Sachs – a perfectly legal move, given accounting rules in the European Union at the time.

Because of the positive value that currency swaps had for Greece, the government needed to pay back what was, for all intents and purposes, a loan from Goldman Sachs. In a separate deal, Greece entered into an interest rate swap which yielded a positive value of €2.8 billion to Goldman Sachs, including €400 million in fees for unwinding other swaps Greece had entered. In its truest sense, this was a fixed-for-floating swap: Greece would send floating-rate payments to Goldman until 2019, while Goldman Sachs would happily send fixed-rate payments to Greece.

Perhaps the best analogy for what happened to Greece is what happened with the U.S. housing crisis. Part of the deal with Goldman Sachs was a two-year period in which Greece would not have to make any payments, similar to what is the teaser rate period. As history showed, without the benefit of rising housing prices, subprime borrowers couldn’t refinance within the teaser window (in which rates were low before springing to unsustainably high levels, hence the housing crash).

Like the teaser loan rates enjoyed by subprime borrowers in the U.S., the payment-free period enjoyed by Greece made it seem like the country’s finances were fine, because the country didn’t have any debt obligations for two-years. Instead of hoping for rising house prices, the Greek government was hoping that an economic boom would spur higher tax receipts, which the government could use to pay down the cost of the currency swap.

While the Greek government enjoyed low borrowing costs, the repercussions were building on the horizon: the deferred interest would have to be paid eventually. In 2005, as noted earlier, Greece was forced to refinance the loan, bringing the total cost of the deal to €5.1 billion. This “actively managed tweak,” as described by Eurostat, allowed Greece to keep the loan a secret, thereby keeping its debt-to-GDP ratio within the European Union’s mandated range. After Greece refinanced its debt, Goldman Sachs sold its obligation to the National Bank of Greece, at a marked-to-market value of €5.1 billion.

But these are just large numbers – why do they actually matter? When Greece initiated the original transaction with Goldman Sachs, it had publicly issued 10-year bonds with a coupon rate of 5.35%. Some quick math: compounding this rate over four years (to 2005), Greece would have owed €3.4 billion; instead, the €5.1 billion obligation represented an astounding 16.3% (!) annual interest rate.

Instead of bringing this issue to light immediately, the government chose to hide the mistake further, extending the maturity of the loan another 18 years to 2037. But by 2010, the costly repayments were too much to handle, and Greece was forced to reinstate the debt onto its balance sheet: the Greek debt crisis was born. Today, it is widely expected that Greece will default on its >€300 billion of obligations, forcing it out of the Euro-zone and back to using the Drachma, Greece’s pre-Euro currency.

In part 9 of 10 of this series, we’ll discuss recent regulatory efforts as a direct result of costly mistakes that have piled up over the past several years directly related to swaps.


Swaps: A basic Q and A

This is part 5 of a 10 part series on currency swaps and interest rate swaps and their role in the global economy. In parts 1 through 4, we discussed the differences between interest rate swaps and currency swaps, as well as the pricing mechanisms for fixed-for-floating, floating-for-floating, and fixed-for-fixed swaps. In part 5, we’ll review the basics before looking at some real world examples in parts 6 and 7.

We’ve fielded some basic questions on interest rate swaps and will provide some clear, succinct answers to make this complex financial instrument a little more understandable.

What is a swap?

A swap is a financial derivative in which two parties (called counterparties) exchange future cash flows of the first party’s financial instrument for the future cash flows of the second party’s financial instruments.

What is the most common type of swap?

The most common type of swap is a plain vanilla swap, or an interest rate swap, and is when one party exchanges its fixed rate obligation with a second party’s floating rate obligation. Currency swaps, sometimes referred to as cross-currency swaps, are also very common, especially in the realm of international financing.

I only recently heard of swaps, how long have they been around for?

The first swap, a currency swap, was a $290 million agreement between the World Bank and IBM, in 1981.

How big is the swap market now?

As the world’s deepest financial derivatives market, the over-the-counter (OTC) swaps market has a notional value of $415.2 trillion as of 2006, according to the Bank of International Settlements (sometimes referred to as the central bank for central banks). At that figure, in 2006 dollars, that would make the swaps market approximately 8.5 times the size of global GDP – combined!

Over-the-counter, what does that mean?

Over-the-counter, or OTC, is off-exchange trading of financial instruments, not just swaps, but stocks, bonds, and commodities as well, directly between parties. While most of the swaps market is OTC, meaning it is without a centralized exchange, interest rate swaps can be standardized contracts regulated by exchanges, like futures.

Who uses swaps?

Swaps are utilized by two groups of people: hedgers and speculators. Bona fide hedgers are using swaps to insulate themselves from future risk, whereas speculators are without hedging need and are in the market for the sake of making money. Under CFTC Regulation 1.3(z), no transactions or position will be classified as bona fide hedging unless their purpose is to offset price risks incidental to commercial cash or spot operations and such positions are established and liquidated in an orderly manner in accordance with sound commercial practices.

So bona fide hedgers come from futures trading?

No! Actually, the first hedge exemption was granted by the CFTC to a swaps dealer for OTC index-based exposure where the swaps dealer writing the swap establishes a futures position to hedge its price exposure on the swap. Sounds complicated, but really, the swaps dealer proved he was protecting his capital rather than using it to speculate on swaps.

I have a fixed rate but I really want a floating rate – what do I do?

If your financing is within your borders and you are using your domestic currency, a domestic fixed-for-floating swap is the type of swap you would initiate with another party. This is known as a plain vanilla swap (see above), and is the most common type of swap.

But I’m not using these funds in my country – I’m funding a project aboard

In this case, this would be a fixed-for-floating currency swap, or a cross-currency swap, and it would require a counterparty in the country in which you’re seeking to finance a project.

I remember where I’ve heard swaps before – didn’t Greece get in trouble with swaps?

This is a complicated subject but we will cover it extensively in part 8 of this series.

In part 6 of 10 of this series, we will lay out simple real world examples of how companies would use swaps to hedge against risk in domestic projects as well as projects abroad.

Just what is an interest rate swap?


One of our team was recently asked to give a simple overview of interest rate swaps and how they work. Below was the explanation we put together, using a comparison between an interest rate swap to a fixed-rate bank loan to illustrate the key characteristics.

We think it is a nice, concise and clear way to explain interest rate swaps so thought we would share it.  Comments welcome.

Bank fixed-rate term loan

Interest rate swap

Bank loan type Separate fixed-rate term loan Borrow floating rate (i.e. 90-day rate resets at market rates plus lending margin). The bank can normally change the lending margin on an annual review of the facilities.
Amount being fixed No flexibility, the full loan amount is fixed. Interest rate swap contract can be entered for any amount, in multiples of $1m. E.g. Borrowing facility of $10m, decide to fix 50% now, therefore enter a $5m swap. Later on the percentage fixed can be increased by doing another swap contract.
Fixing of interest rate Per loan documentation, includes bank lending rate for term (say 5 years) plus bank lending margin = all up fixed interest rate that does not change over the term of the loan Interest rate fixed by entering an “interest rate swap” contract. The borrower pays fixed rate and receives floating rate under the swap contract. The floating interest rate received under the swap for the next 90 days nets off against the 90 day interest rate paid on the physical floating rate loan above. Net result is an all up fixed interest rate, being the fixed swap rate plus the normal bank lending margin on the borrowing facility.
Flexibility Cannot unwind early or unknown penalties applied by the bank for early termination. At any time the swap can be unwound or closed down. If term swap rates subsequently increase, the swap is closed down at a realised cash gain –  being the difference between the contracted swap rate and the higher market swap rate for the term left to run (and vice versa).
Documentation Normal bank loan documents Interest rate swap is a separate legal document under standard “ISDA” bank terms.
Term of fixing Interest rate is fixed for the term of the loan A fixed rate swap can be for any term, does not have to be the same maturity date as the underlying bank loan facility. May be shorter or longer.
Use of bank credit limits Loan principal plus 12 months interest cost usually. Loan principal plus 90 days interest cost, plus credit usage of swap agreement (normally 4% x number of years of swap x principal amount). In addition, if market swap rates subsequently reduce to below the contracted fixed rate of the swap, the bank will add on the unrealised “marked-to-market” revaluation loss onto the total credit usage. The bank normally imposes a a maximum term for swap contracts. They may allow fixing the swap interest rate for 10 years with a “right to break” clause that allows the bank to close down the swap after 5 years if they don’t like the borrower’s credit any more.
Cashflow Interest paid monthly or quarterly. Interest on 90-day physical borrowing paid every 90 days and then the bank calculates the difference between the swap fixed rate and market floating rate every 90 days, with the borrower paying the cash difference between the two interest rates to the bank and vice versa.
Fixing the interest rate in advance of loan drawdown Not really possible. “Forward start” swaps can be entered with the fixed rate commencing from a predetermined date. An option can be purchased to enter a fixed rate swap at a future date as well (“swaption”).

Are interest rate swaps heading the way of the dodo?

Previously I wrote about the bad press interest rate swaps have been receiving and that I felt much of the criticism was unjustified. I firmly believe that a lot of the negativity has been due to people not understanding why swaps are useful and, because of this, they fear their use.

Further muddying the waters has been the recent announcement of new margin requirements for over-the-counter (OTC) swaps. The Commodity Futures Trading Commission (CFTC) has published several important rules for compliance, including a proposed start date of October 12. This has been coming for some time with the Dodd-Frank Act requiring most OTC derivatives to be traded on a Swap Execution Facility (SEF). (A SEF is “a trading system or platform in which multiple participants have the ability to execute or trade swaps”.)

Image courtesy of The Telegraph

This has got everyone excited and even saw Risk Magazine undertake a poll to see what the impact of the proposed margin requirements on uncleared trades would have. The results, while on the face of it are not surprising, could well be mis-leading.

60% of respondents to the survey thought end-users will opt not to use derivatives as a result of initial and variation margins requiring to be posted on uncleared swap trades. When the sort of money being talked about in collateral is in the trillions it is not surprising that there is some concern over this, and questions over the use of swaps in the future.

However I think we need to “back the truck up” a bit here. These new regulations do not relate to non-financial entities. The new proposals state “the margin requirements need not apply to non-centrally-cleared derivatives to which non-financial entities that are not systematically-important are a party.”

So corporations are exempt and therefore can continue to use swaps as they have done before – as a risk management tool to hedge future movements in interest rate risks. Interest rate swaps have got organisations into trouble in the past and no doubt will do so in the future, but almost without exception the reason that the deals have gone sour is because the people entering into them in the first case did not understand them. Sure the sales people have been gung-ho in some cases and they may or may not have been the best tool to use at the time, but again if the organisations entering into the swaps had a clear understanding of their use, most of these problems would be averted.

It is timely to remind ourselves of what needs to be in place to confidently enter into derivative deals. Firstly, make sure you have an exposure that the derivative will accurately hedge.  If as a borrower you have floating rate debt then an interest rate swap whereby you swap your floating interest payments for fixed interest payments would be appropriate. If you have floating rate debt and you sell an option to receive a premium to offset your interest payments, then this is speculation and is not managing your interest rate risk as you still have unlimited risk on the top side.

Secondly, understand the product itself well enough so you know the risks you are taking on board. If you are unsure DO NOT ENTER THE TRANSACTION. Normally plain vanilla deals will suffice, if you move away from the plain vanilla again you need to understand intimately what you are getting into. If interest rates go up what is the impact on your portfolio? Likewise if interest rates go down, what does that mean to you?

Finally you need to be able to record, report and value these transactions so that at all times you have a good handle on your current position and what might happen in the future if interest rates change. If you can’t capture your deals appropriately and value them then this is when unpleasant surprises can happen. You need to know your position at all times.

So changes are on their way, but as a business there is no cause for concern that instruments like swaps will no longer be able to be used as a risk management tool. If you follow the common sense rules then they are still an important way to manage your risks – despite what the regulators may seem to be saying.

Richard Eaddy is the CEO and founder of Hedgebook and the Managing Director of ETOS Ltd, specialists in treasury outsourcing services. Richard has worked in the corporate treasury risk management industry for more than 20 years. He has held senior roles in large corporate treasury departments in both New Zealand and Europe, provided treasury risk management advice to major corporations and for the last ten years has headed up the largest treasury outsourcing company in Australasia. Richard can be contacted at