It looks like a lot of fun to be a world-class golfer or skier. You get paid millions of dollars to do what costs the rest of us big sums of money, you bask in the constant adulation of thousands of screaming fans – whoops, bad example, for some inexplicable reason golfers need absolute silence while they play – and you visit the finest courses or slopes all over the world. Best of all, sometimes you can even win a cow.
After Luke Donald took the Dunlop Phoenix trophy in Japan late last year, he won a legendary Miyazaki beef cow – each member of this special breed of cattle gets a name, drinks beer, and experiences a sake massage to preserve its outstanding qualities. When Lindsey Vonn won the Val d’Isère Super G in France, she elected the cow option as well, naming her prize Olympe and sending the bovine award to live in a friend’s barn in Kirchberg, Austria.
Of course, there’s a huge difference between winning a cow and getting said cow to your backyard grill / your friend’s barn. Luke’s ordeal lasted roughly half a year – first, he was told that the cow could not be physically delivered to the US; then, that the cow was still alive and consequently the meat would not be available; lastly, that it wasn’t just one cow but parts of many cows that he would be receiving. It took the diligent work of an external advisor in the food import business to secure the beef, flash freeze it in individual portions, and deliver it to the golfer. Similarly, Lindsey had to wrangle with the local French cheese farmers, who assumed she would not want physical delivery, and perhaps wanted to exchange below-market cash for her newfound pet in order to make more of their delicious local Reblochon.
Not all of us will be fortunate enough to win a cow prized for its beef or its gentle companionship, but we can learn plenty about sound hedging practices from Luke and Lindsey.
Negotiate key terms in advance: Luke’s experience was probably worsened by the fact that he had to fly to the next tournament, and he could not stay to negotiate the cow transfer protocol. If he had done so, he might have been able to arrange for better conditions for timely delivery, cost of freight, and net weight transferred after expenses. In the same way, the sooner you can begin discussing credit terms on the interest rate swap that will accompany your loan, the better – few elements of a financing can be more needlessly detrimental than signing on to a higher-than-market credit charge, unfavorable collateral requirements, or bad breakage language in your swap.
Determine cash settlement or physical delivery: Once Lindsey decided to take cow rather than cash, she had a big challenge – where to put 1200 pound Olympe. She was fortunate to have a friend with Alpine pasture land over in Austria, but that was five hundred miles away! In the world of commodities, specific company demand will usually require physical delivery, but different ports offer differential pricing. For interest rate hedging, when deciding between a cash-settled or physically delivered swaption, note that the former may require a cash event at maturity, while the latter may be exercised into an off-market swap – each has peculiar hedge accounting ramifications.
Consider implications of OTC versus cleared: Luke thought he was getting a specific, highly customized object (a certain cow with a name). In fact, he was getting a certain amount of a non-specific, non-customized object (two hundred pounds of beef). An OTC swap can be completely customized to handle the precise conditions set by your loan documents (for instance, LIBOR rounding of all types is allowed), while a cleared swap has constraints on its definition (for instance, no LIBOR rounding is permitted). The mismatches created between a cleared swap and the loan it hedges need to be well understood.
Understand the normal purchases and normal sales (“NPNS”) exception: Lindsey was looking for a bovine pet, rather than hoping to build a business as a dairy farmer. But if she had been, her decision to accept cash rather than cow might have meant she couldn’t qualify for the NPNS exception, which exempts a transaction from being accounted for as a derivative. For instance, a company that receives electricity physically under a power purchase agreement could qualify for the NPNS exception, but what if it has an ISDA provision that permits financial settlement if its supplier cannot deliver power? Does this failure to deliver clause result in an inability to elect the NPNS exception (and therefore derivative accounting) for the power purchase agreement? The accounting rules can be very complicated on these points, but they constitute a critical piece of the overall hedging analysis.
Right now, we imagine Luke is enjoying a juicy tenderloin and contemplating the differences between over-the-counter versus cleared cattle, while Lindsey is frolicking in the Austrian Alps with Olympe and singing “The Hills are Alive with the Sound of Hedging.” If you have any specific questions about your hedge structuring, execution, documentation, or accounting, don’t have a cow! Just give us a call and we’ll be happy to chat with you.