The true cost of hedging
Managing Partner, Chairman
Global Head of Corporates
Kennett Square, PA
Corporates | Kennett Square, PA
SummaryEnsuring an effective, compliant hedging program means assessing both visible and hidden costs across all hedging activities, including strategy and pricing, legal and regulatory, and accounting.
- Most companies experience the visible cost of hedging in the form of the carry cost (difference between the swap rate and SOFR when swapping floating rate debt).
- Embedded within this visible cost reside many hidden costs — ultimately the difference between paying retail or wholesale for a hedge.
- Ensuring an effective, compliant hedging program means assessing both visible and hidden costs across the spectrum of hedging activities.
How hidden costs impact hedging decisions
With any derivatives use comes a discussion of cost — both visible and hidden. To ensure a cost-efficient program, treasury teams should consider the best ways to reduce the cost of hedging across three key areas: strategy and pricing, legal and regulatory, and accounting.
Assessing visible and hidden costs
Visible and hidden costs abound in the strategy and pricing arena. Most companies experience the visible cost of hedging in the form of the carry cost (difference between the swap rate and SOFR when swapping floating rate debt). Steep yield curve environments can discourage hedging as the visible cost may be viewed as dilutive to earnings for public companies.
Embedded within this visible cost, though, reside many hidden costs — ultimately the difference between paying retail or wholesale for a hedge.
Some companies rely on their bank counterparties to clarify the hidden and visible costs by asking about markups. The Dodd-Frank Act even requires that bank counterparties decompose hedge pricing by providing “mid” market pricing on transactions.
Unfortunately, these bank counterparties are not providing these transactions under the umbrella of a fiduciary advisor to a company. As a result, incentives to either help a company ask the right questions or fully understand how one bank's price may differ from another bank's price, do not exist.
One strategy that companies may choose to utilize in reducing the cost of hedging may be to create a competitive environment for their banks in pricing. A challenge with this approach includes increased relationship friction costs as relationship banks may not appreciate this approach. Additionally, unless banks are accustomed to working in an auction environment run by a treasury team, they may question either the timing of the process or the parameters under which a transaction may be executed. As a result, the banks may not put forward their best price and, ultimately, lead to higher rather than lower hidden costs.
Benchmarking costs against industry peers
A critical benchmark for most companies engaging in any activity with their banks is knowing what their peers pay for similar services. Unfortunately, there is no database in which a company can look up its peers and determine the appropriate markup for an interest rate derivative. Some treasury teams opt to partner with an established advisor with deep industry data points to make these markups more transparent and enable a process that allows them to separate out and appropriately value the hidden costs that come along with interest rate derivatives.
A treasury team with a clear view of their hedging costs is prepared to find the best deals on upcoming derivatives transactions and more effectively allocate business among multiple banking relationships.
The below chart illustrates costs based on different types of hedging programs and structures. For each type of hedging program, the figure shows an example index hedged in different ways, comparing across alternatives using the sensitivity of 1 basis point (0.01 percent — commonly known as the DV01) or 1 pip (0.0001 in the EUR-USD exchange rate, for example). The bank profit on any transaction varies based upon a number of factors including the credit intensity of the derivative (how large of a liability can it become?) and the creditworthiness of the company.
The cost of compliance
Hidden costs extend beyond pricing into legal and regulatory requirements as well. Negotiating ISDA agreements tends to be a frustrating and lengthy process for most treasury teams given their infrequency. In-house counsel may not possess the specialized knowledge necessary to drive the process forward in a timely manner. Given the pace of market changes, a delay of even a few days can impact the visible cost of hedging by hundreds of thousands of dollars. Engaging specialized external counsel brings its own visible costs, which often exceed tens of thousands of dollars. Even then, the speed with which external counsel may be able to push the ISDA negotiation process along may be limited by their relative lack of volume of this type of work as relatively few partners at large law firms have attained such a position via ISDA negotiation alone. Ultimately, finding a resource with specialized ISDA knowledge, access to industry-specific terms and deep relationships with banks can best enable treasury teams to cut down these hidden costs.
Derivatives have entered the realm of regulated financial products over the past several years. The cost of regulatory compliance for U.S.-based firms tends to be a hidden cost. Activities such as adhering to ISDA protocols, obtaining legal entity identifiers and obtaining and maintaining the end-user exception from a firm’s Board of Directors takes real time. If not already completed, these activities can add to the time before a hedge can be executed. Even when completed, these activities take ongoing time to ensure compliance. These soft costs should be considered when weighing whether to manage compliance in-house or through an external partner who can ensure compliance while enabling the treasury team to focus on strategic initiatives.
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Hedge accounting considerations
Finally, no discussion of interest rate hedging is complete without recognizing that accounting treatment really matters. Some treasury teams can simply hand over the topic to their colleagues in financial reporting. Most, though, need to essentially become quasi-experts in the standard because interest rate hedging is sufficiently rare as to render the need for in-house expertise within accounting relatively low. As a result, the hidden cost of housing this expertise within treasury becomes very real — busy treasury teams often lack the time and resources to become experts in this area. As a result, the risk of error is much higher. Additionally, with a changing hedge accounting standard, it is challenging for treasury professionals to stay on top of the newest allowances in the guidance, which risks creating sub-optimal hedging programs.
A holistic approach
Integrating efforts across all of these domains can have a significant positive impact on a company’s hedging costs and ultimately lead to the significant reduction of hidden costs. Recently, we worked with a company that had extended its term loan maturities and wanted to address its interest rate risk. While it had gotten feedback from banks around different strategies, many of these weren’t necessarily fully compliant with hedge accounting requirements. By engaging Chatham, the company was able to put together a hedging strategy that appropriately mitigated the risk of rising rates while achieving full compliance with both regulatory and accounting guidance. We negotiated ISDAs in under a week and allowed the company to cut the markups on their trades by over 60%, ultimately achieving wholesale pricing.
Assessing your hedging program
Ensuring an effective, compliant hedging program means assessing both visible and hidden costs across the spectrum of hedging activities, including strategy and pricing, legal and regulatory, and accounting. Once the full cost of the program is transparent, you can begin to identify the most cost-efficient mix of internal and external resources to support it. Because interest rate hedging is inherently a rare event, many treasury teams elect to engage a strategic advisor, much as they would with attorneys and other professional advisors. Teams with a higher frequency of interest rate hedging may elect to bring some resources in-house while outsourcing others to a strategic partner. In either case, a deep understanding of the full cost of hedging positions your treasury team to implement a hedging strategy that successfully addresses rising interest rates.
Chatham Financial corporate treasury advisory
Chatham Financial partners with corporate treasury teams to develop and execute financial risk management strategies that align with organizational objectives. Our full range of services includes risk management strategy development, risk quantification, exposure management (interest rate, currency, and commodity), outsourced execution, technology solutions, and hedge accounting. We work with treasury teams to develop, evaluate and enhance their risk management programs and to articulate the costs and benefits of strategic decisions.
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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.22-0184
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Interest rate swaption
An interest rate swaption is an option that provides the borrower with the right but not the obligation to enter into an interest rate swap on an agreed date(s) in the future on terms protected by the swaption.
A cancellable swap is a combination of an interest rate swap and a receiver’s swaption that may be cancelled by the borrower at no cost on an agreed future date.