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ANALYSIS: Economic hedges Give them wings!

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Rodgers Mavhiki uses a few simple but practical examples to illustrate current challenges and explore ways of potentially improving hedge effectiveness

Economic hedges are common practice, yet you often hear people saying that the fair value movements are not making sense. Most banks and treasuries of big corporates take hedges on exposures to fixed interest rates – be they bonds, loans and advances, debt instruments, just to mention a few. Despite most entities having a multitude of economics hedges, these hedges are widely misunderstood culminating in profit and loss volatility due to ineffectiveness.

Economic hedges are used to reduce or eliminate exposures to economic risks such as interest rate risk, foreign exchange risk and credit risk. Economic hedges are structured in such a way as to avoid complex hedge accounting while achieving the same result as if hedge accounting was applied.

EXAMPLE 1

Scenario

Entity A acquires a government bond for R400 million with a fixed coupon rate of 10% paid semi-annually. The entity does not want to be exposed to interest rate risk so it decides to buy a pay-fixed receive-variable swap. The variable rate on the swap is three months Johannesburg Interbank Agreed Rate JIBAR plus a spread.

How the economic hedge is carried out

To ensure that the fair value movements in the swap eliminate the fair movements in the bond, Entity A may buy a swap with the same fair value movement (though opposite direction) as the bond, thus the total fair value movement of both the bond and the swap on the day that the swap is bought is zero, this is often called delta-neutral hedging.

The entity may also match the principal terms of the bond and swap, for example:

•         The swap will also have a notional amount of R400 million

•         The fixed rate on the swap will also be 10%, and

•         The swap will have the same maturity date as the bond

This is referred to as critical terms matching (CTM). CTM will result in fair value movements that are highly likely to fully offset.

The use of CTM or delta-neutral hedging strategy will impact the effectiveness of the economic hedge.

Impact on effectiveness and remedies

The bond will be fair valued off the bond curve whereas the swap is fair valued off the swap curve. This may be a source of ineffectiveness and is called basis risk. Basis risk is best mitigated by rebalancing. Rebalancing entails adjusting either the hedged item (bond) or the hedging instrument (swap) in order to maintain a desired hedge ratio.

The bond coupons are paid semi-annually, yet the swap is re-priced every three months; this timing difference may result in ineffectiveness. Similar to basis risk, the impact of timing differences on hedge effective can be reduced by rebalancing.

EXAMPLE 2

Scenario

The facts are the same as in example 1 and Entity A decides to apply a delta-neutral hedging strategy. Entity A has an ISDA agreement with the swap counterpart but does not have a credit support annex (CSA) as it is not mandatory.

Impact on effectiveness and remedies

If the hedge was entered into before CVA/DVA became the buzz words in 2013, chances are the fair value of the swap did not take into account credit valuation adjustment (CVA) or debt valuation adjustment (DVA). IFRS 13 now requires the fair value of derivatives to take into account CVA/DVA. As the swap counterparty does not have a CSA with Entity A, the CVA/DVA for the swap is likely to be significant which may affect the effectiveness of the economic hedge.

Entities should remember to include CVA/DVA in calculating the fair value of swaps for delta-neutral hedging strategies. Another way of minimising the impact of CVA/DVA on hedge effectiveness is through buying hedging instruments (in this case swaps) from entities that you have bilateral CSA agreements with, as the CVA/DVA will be insignificant.

EXAMPLE 3

Scenario

The Corporate Cluster of Bank B has a fixed rate loan (receivable) to the amount of R200 million. The treasurer of Bank B decides to hedge the loan using a pay-fixed receive-variable swap. Owing to changing economic factors the corporate cluster and the client agree to change interest from a fixed rate of 12% per annum to three months JIBAR plus 3% spread.

Impact on effectiveness and remedies

The renegotiated terms of the loan will affect the effectiveness of the hedge. The loan now generates variable interest yet the swap is paying a variable rate, thus the fair value movements in both instruments will not eliminate but will move in the same direction rendering the economic hedge ineffective.

This scenario is common with CTM hedging strategies, as management often regard the hedge as locked in and do not necessarily review the position on a continuous basis.  Management should periodically review all economic hedges to determine if the hedging strategy still holds water. In this instance the treasurer has to close out the swap and if s/he still wants to hedge the loan, it may be more effective to acquire a pay-variable receive-fixed swap.

EXAMPLE 4

Scenario

The Retail Cluster of Bank B has a portfolio of fixed rate loans amounting to R100 million. The loans are on average payable in five years. The treasurer of Bank B decides to hedge the portfolio of loans using a five-year pay-fixed receive-variable swap. The swap has a notional amount of R100 million. Within the first year, loans amounting to R15 million were prepaid.

Impact on effectiveness and remedies

The critical terms no longer match, as the portfolio of loans now has a carrying amount of R85 million while the swap has a notional amount of R100 million; thus the economic hedge is likely to be ineffective.

Prepayment risk is addressed by continuously monitoring the hedge items (portfolio of loans) and hedging instruments (swap) and rebalancing if required. In this example the treasurer can close out the swap with a notional amount of R100 million and replace it with a new swap with a notional amount of R85 million or alternatively, increase the portfolio of loans back to R100 million.

EXAMPLE 5

Scenario

Company C buys corporate bonds with a fixed coupon in year 0. The bonds have an option to convert into ordinary shares of the bond issuer. At the time of bond purchase, the option is deeply out of the money. The CFO of Company C hedges the interest rate exposure using a swap.

In year 1 the option is deeply in the money.

In year 2 the bond is converted into shares.

In year 3 Company C buys new fixed rate bonds and decides to use the existing swap to hedge the bonds.

Impact on effectiveness and remedies

Year 1

As the option is now in the money it will have a significant fair value, which may affect hedge effectiveness if a delta neutral hedging strategy was applied. In year 0 the option had a negligible fair value and was not taken into account as part of the delta-neutral hedging strategy.

To ensure effectiveness, the CFO will have to consider rebalancing the hedging relationship by buying more swaps.

Year 2

Fair value movements in the swap will not offset the fair value movement in the shares, unless by coincidence. As the entity no longer has interest rate exposure, the CFO may close out the swap.

Year 3

If Company C uses a CTM hedging strategy, there might be ineffectiveness as the swaps are off-market. The swaps will have a fair value other than zero. A delta-neutral hedging strategy is more suitable when hedging using off-market derivatives.

In conclusion, it is clearly evident from the above examples that it would be more prudent for an entity to continuously review the economic hedges and strategies that are in place to avoid incurring unnecessary losses. Rebalancing or closing out derivatives at opportune moments requires proactive involvement! Review your economic hedges continuously and give them wings! ❐

Author: Rodgers Mavhiki CA(SA) is an IFRS expert and a Strategic Accounting Advisor at Nedbank