Risk management trends and tips for corporate treasurers
A look at the latest Risk Management practices to help corporate treasurers.
Swaptimisation – getting good value on derivatives
Corporates dealing with derivative transactions can hold positions with a number of banks, each one with different exposures and pricing methods. This can result in a significant variation in the fair value of a derivative from one bank to the next.
Swap optimisation, or swaptimisation analysis, is a good way to reallocate the derivative portfolio and realise monetary value without altering the risk profile. Other benefits include increased dealing capacity by freeing up bank credit lines and simplifying the derivative portfolio.
The analysis shows the current and potential future exposure on the corporate’s derivative positions from the perspective of each bank involved. It then estimates the resulting credit and funding reserves as well as the capital allocated, and identifies the value-add opportunities. As such, not performing this exercise has been likened to ‘leaving money on the table’.
CSA – striking the right balance
In recent years, the price of derivatives has been going up because of increased credit, funding, and capital costs, while the availability of derivatives has been going down due to capital and credit line restrictions.
As such, many corporates are evaluating the use of CSAs (Credit Support Annexes) to improve pricing and free up credit lines. CSAs are legal agreements between two parties to post or receive collateral against the mark-to-market of a derivative trades portfolio.
They reduce the credit exposure between a corporate and a bank and can lead to better pricing and reduced risk. But credit risk is replaced by liquidity risk, the cost of funding the collateral can be high and there is a lot of admin involved.
Corporates can strike the right balance between the pricing benefits and liquidity risk by changing certain terms of the CSA, including the point at which collateral is posted and how often collateral transfers are made.
Businesses are taking advantage of historically low interest rates and locking them in, or pre-hedging, for a number of their future debt refinancings and for longer than ever. They might, for example, cover up to half their debt issuances over the next 10 years.
Corporates are used to pre-hedging one bond at a time, and often for shorter periods like six months, but doing it on such a scale is new to them and there are serious concerns about how the accounting will work.
A host of accounting tools and techniques are available which make bigger, longer prehedging possible. It is not as challenging as it first seems because it’s not necessary to know the exact issuance terms upfront. It is enough to have a “highly probable” future exposure to varying interest rates.
A specific concern surrounds what to do if the eventual issuance tenor does not match the pre-hedge. The key to managing this is flexible hedge accounting. For example, an issuance longer than the pre-hedge would be partial term hedged, whereas an issuance shorter than the pre-hedge would be fully hedged with the remainder continuing as a hedge for the future.
Managing interest rate risk
Traditionally, companies would hedge interest rates – swapping longer-term debt from fixed to floating rates – by swapping from the fixed rate into Libor.
But Libor includes bank credit risk and can spike during times of stress, like it did during the financial crisis. The credibility of this rate has also been put into question following the recent scandal around it in the banking industry.
As such, very few corporates are swapping longer-term debt to floating, believing that there is no significant cost benefit and interest rates can only go up.
Corporates are swapping their current Libor-based floating rates into an overnight interest rate, which relates to the money deposited by commercial banks with their central banks overnight. Typical overnight rates include the Fed Funds rate for US dollars, EONIA for euros, and SONIA for sterling.
A ‘paid to wait’ strategy enables a corporate to get paid upfront and wait to swap to a floating rate when it is at a pre-agreed, better level. It means they don’t benefit if the rate goes higher than that, but they get the security of cash upfront. If rates don’t rise to the agreed levels, the cost of carry is reduced by the premium received and a new “paid to wait” swap can be set up.
A number of large, multi-national corporates are increasingly looking to expand their operations in China to boost growth, but the banking and regulatory landscape is completely different from what they’re used to.
Although banks now offer a range of products to help, they are only effective if they match the corporate’s wider strategic objectives.
Companies are now optimising their China-related operations – including funding, hedging and transactional banking – to take a holistic view to ensure they choose the right solutions.
They are looking closely at how they should fund their operations, manage cash and hedge FX risk in China through the same lens. Then they are able to map the available solutions to their own business and the relevant regulatory issues. The same approach can be applied to any emerging markets country.
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