Interest rate swap pricing: pulling back the curtain on syndication
Managing Partner, Board Member
Global Head of Corporates
Kennett Square, PA
To choose the best interest rate hedging strategy, understand the pros and cons of derivative syndication as opposed to competitive auctions, direct negotiation and other alternatives.
Corporates approaching the interest rate hedging market face numerous decision points; among those is choosing the right execution strategy. If a corporate has a material amount to hedge, more than likely one or more of its lending banks will offer syndication as a way to streamline the hedging process. Against the backdrop of alternative execution approaches, such as competitive auctions and direct negotiation, syndication has considerable merits and drawbacks. Before agreeing to this arrangement, it is worth gaining an understanding of the relevant pros and cons.
When it comes to interest rate hedging, most corporates operate within what seem to be two mutually exclusive goals: the goal of achieving efficient pricing on the derivative and the goal of fostering ongoing healthy banking relationships. In the context of syndication, often the syndicating bank reaps the highest relational reward, gaining the ability to control the process and set pricing. In contrast, the other banks incur the relational cost of not being the syndicate lead. A countermeasure to this dynamic is to host a competitive auction, which levels the playing field for all bank participants, giving them all equal opportunity to bid competitively.
Efficient and transparent pricing
When managing the interest rate swap process through one counterparty, the corporate hedger will inevitably be paying a markup to the particular syndicate lead bank. Moreover, if several of the different participating banks in the syndicate have a different credit charge in mind, chances are the group will land on the worst common denominator. In the absence of quantitative tools to model the appropriate credit charge for a given scenario, a syndicated swap has the potential to levy a significant hidden cost to the hedger.
Credit constraints and administrative burden
If the corporate hedger is concerned about having sufficient credit capacity and finding enough counterparty banks that are willing to take on this risk, then syndication can be an effective way to use the lead bank to navigate that process. To the extent that time and resources are a major constraint, syndication could somewhat reduce the administrative load as well.
Any approach to execution strategy — ranging from competitive auctions to syndication to direct negotiation — can lead to a good outcome with the right level of experience, knowledge, and tools at your disposal. An independent advisor can help navigate these considerations, ensuring the corporate hedger can enter the market with an approach that is tailored to their needs.
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Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.18-0276