May 9, 2011
Economists are generally not like you and me. While we live in the here and now, they seem to find it more pleasant living life in the long run. This so-called “perspective” allows them to say things like “inflation is merely transitory,” or that we will “gradually return to higher levels of resource utilization.” Never mind they are trivializing the increases in food and fuel prices that are busting many American wallets right now, or downplaying the plight of the long-term unemployed. Although his perspective may come across as cold-hearted or callous, the economist is really saying that our present predicament is but one peak or valley in the larger business cycle, with better days yet to play out as the economy strengthens and finds its footing once again.
Taking a cue from our economist friends, we can learn a lot about derivatives by adopting perspective as well. This involves taking the longest view possible given the facts before you, and minimizing the reaction or overreaction to snippets and snapshots of data when there is still more to come. By expanding your frame of reference when entering a hedge, over the life of your deal, and at maturity or early termination, you add rich detail and context to the discussion that simply escapes the here and now crowd.
To Hedge or Not to Hedge. Why should I hedge? I mean, I am enjoying the lowest rate environment of my life. Why would I want to pay up the curve for interest rate protection? Well, maybe you should, but maybe you shouldn’t. Having perspective means you are viewing your deal over the longer term (life of your loan is a good horizon), and are comfortable with your own view on future interest rate movements. If you believe we will stay low for the remaining life of your loan, and can live with higher floating rate debt if you are wrong, then hedging is not in the cards for you. If interest rate risk could change your present situation into a debt service nightmare down the road, then you would want to consider taking the issue off the table with a pay-fixed swap or interest rate cap. Having perspective will not necessarily drive you to hedge, but it will not permit you to judge the whole experience based on just a single month or data point nor “passed performance” either.
Valuations. Are you the type of person that cringes when you open your monthly derivative valuation statement? How underwater can it go? When will it possibly recover? Do you hit the refresh button on our website five times a day? Take a deep breath and ask yourself, “What am I doing?” When your swap matures, the position reverts back to zero value. If you put on a swap with plans on holding the position to maturity, and nothing has changed those plans, then you really don’t care how large a liability your swap can be in the interim. True, no one likes earnings volatility, and anyone filing GAAP financials should strongly consider hedge accounting to dampen volatility as much as possible. But the fact remains that the position will retire as neither an asset nor liability at maturity. A snapshot in time is deceiving relative to your original decision to hedge, and is little use to the long-term hedger holding the position to maturity.
Early Terminations. You just found out you are selling the underlying asset. And yes, your lender let you know there is this matter of an underwater swap that needs to be addressed at closing. Well, first of all, congratulations are certainly in order, as selling any property or business in this tough economy is no small feat. Next, place the breakage in context. The swap is a liability because rates are lower than when you entered. That means your next deal will start out with lower interest rates as well. Did you ever consider that the low rate environment may have made it possible for your buyer to make this deal? It may have even played a role in getting you a higher price. So, did you know that rates would fall? Then why are you beating yourself up over the negative valuation on the swap? Oh, but if you didn’t hedge, there would be no breakage right now to worry about. True, but you also recognized that you had interest rate risk, and it could have just as easily turned out bad without the hedge. Perspective involves not only a longer term time horizon, but also a comprehensive view of the facts in time and space that make up a decision. Don’t confuse “twenty-twenty hindsight” with perspective, as the fullness of time reveals things you can’t possibly know at the inception of a deal. Perspective allows you to come away from the situation knowing that you made the right original decision, given the facts that were presented to you at the time.
When it comes to hedging, Chatham can help you put things into perspective, view your decisions in the context of the larger business cycle, and adopt the longest view possible given the facts. While we routinely say that Chatham is view neutral, we can help you take action on your own personal view given the currency, interest rate, or commodity risk on the table that you wish to mitigate. Remember, if a hedge is truly a hedge, that is the only perspective you should need. You have removed risk and should almost always have the hedged item offsetting the value of the actual hedge, and you will sleep well knowing you took the right action based on the facts before you and your long-term perspective.