The views expressed in this column are solely
those of the author and do not reflect the views of SVB Financial Group, or
Silicon Valley Bank, or any of its affiliates.
A firm cannot avoid interest rate risk when borrowing. The
CFO or Treasurer with a loan based on a floating rate index, such as Prime or
LIBOR, is exposed to the risk that short-term interest rates will rise, causing
borrowing costs to rise. The tough questions are, of course, will rates rise
further than they have done so already, and if so, will they rise fast and far
enough to have a significant impact on your budgeted interest expense.
Without a lot of fanfare, expectations of short-term
interest rates have risen considerably over the last few weeks. Eurodollar
futures prices currently imply a 3-month LIBOR rate of 2.03 percent for the December 2012 contract, up from trading at 1.54 percent just three weeks ago and considerably
higher than 0.28 percent, where 3-month LIBOR currently resides.
The London Interbank Offered Rate (LIBOR) is a reference
rate based on the interest rates at which banks borrow unsecured from one
another, and it is the most widely used benchmark for short-term interest rates
in the world. The rate is set each day by the British Bankers Association,
which calculates the average short-term inter-bank deposit interest rates among
the most creditworthy banks.
The U.S. short-term interest rate market is one of the
largest and most efficient in the world. All available information about our
economy, inflation, and monetary policy is fully reflected in today's interest
rates. The events that will drive the direction of tomorrow's and next year's
interest rates are events that we may not fully anticipate today. In such an
efficient market, a financial officer will find it difficult if not impossible
to consistently "beat the market" by forecasting the direction of interest
Diversification can be an important strategic tool in
managing interest rate risk in these uncertain markets. A firm that hedges its
floating rate debt financing will experience lower interest costs than unhedged
firms if interest rates move higher.
One of the best diversification strategies involves creating
a mix of fixed and floating rate debt. With floating rate debt, a firm borrows
at the short end of the yield curve (where interest rates are usually lowest)
and retains the ability to benefit in a stable to declining interest rate
environment. With fixed rate debt, a firm is protected against future increases
in short-term interest rates. A mix of fixed
and floating rate debt helps a firm move toward an outcome that is better than
the worst case scenario. (See Chart 1) Note
that most firms cannot obtain fixed rate financing from their banks and even
fewer are able to issue fixed rate notes or bonds, so they effectively create fixed rate financing by hedging their floating
rate financing using interest rate derivatives.
Chart 1: Benefits of
A firm that decides to hedge their floating rate financing has
several derivative instruments to choose from. A financial officer should be
aware of the various choices before making a final decision. The two most
popular derivative instruments used to hedge floating rate debt are interest
rate swaps and caps. Here are the definitions for each:
Interest Rate Swap:
An agreement between two parties to exchange or swap interest payments, based on a "notional" amount, through a
specified maturity date. No principal payments are exchanged. A typical
interest rate swap involves exchanging a swap fixed rate for a floating rate
index — typically LIBOR or Prime.
Aside from the advantage of being able to lock in a swap
fixed rate for the duration of the loan, the other key advantage in using a
swap involves the ability to benefit from "bilateral pre-payment" — should you
ever elect to terminate the swap prior to maturity and current interest
rates are higher than they were at swap inception, you may actually receive
a payment from your swap counterparty (your bank) equal to the change in market
value of the swap. Conversely, the downside to bilateral pre-payment – should
you elect on early termination and current interest rates are lower than
they were at swap inception, then you will be required to make a payment
to your swap counterparty equal to the change in market value of the swap. One
other disadvantage: if interest rates drop or only increase slightly,
then you may end up paying more in interest expense over the life of the swap
compared to only having a floating rate facility with no swap.
Interest Rate Cap: A contract between two parties in which the
cap seller agrees to pay the cap buyer if an interest rate index (e.g., LIBOR
or Prime) rises above a specified level (the cap "strike rate"). In return for
this insurance protection, the buyer pays the seller a premium shortly after
the transaction is executed.
The cap premium is determined by the strike rate, the
coverage period, the notional amount and the level of interest rate volatility.
As a general rule, the cap premium will be higher when the strike rate is
lowered, the coverage period is lengthened, the notional amount is increased or
interest rate volatility is increased.
Each instrument has certain advantages and disadvantages
over the other in terms of certainty, upside and downside risks and upfront
costs. Each provides a distinct risk profile in different interest rate
environments (see Chart 2).
Chart 2: Financial
As these instruments are typically traded between a
financial institution and its client or between financial institutions, they
are operating in the Over-the-Counter (OTC) derivatives market. One of the
advantages of the OTC derivatives market is its flexibility. A firm can
customize a transaction to hedge its own unique debt obligation. It can
customize its: 1) coverage period — a derivative can start on a "spot start"
basis or an a forward date of a firm's choosing, 2) notional amount — can be a
constant amount through final maturity or it can amortize to match the
underlying loan amount, or 3) floating rate index — can use LIBOR (one, two,
three or six month) or Prime.
Managing financial risk is as much an art as it is a
science. Hopefully, in this article I have described ways to potentially improve
the odds of success. A growing number of finance officers are considering using
interest rate derivatives to help manage their interest rate exposure in these
increasingly uncertain markets.
The views expressed in this column are solely those of the author and do not reflect the views of SVB Financial Group, or Silicon Valley Bank, or any of its affiliates. This material, including without limitation the statistical information herein, is provided for informational purposes only. The material is based in part upon information from third-party sources that we believe to be reliable, but which has not been independently verified by us and, as such, we do not represent that the information is accurate or complete. The information should not be viewed as tax, investment, legal or other advice nor is it to be relied on in making an investment or other decisions. You should obtain relevant and specific professional advice before making any investment decision. Nothing relating to the material should be construed as a solicitation or offer, or recommendation, to acquire or dispose of any investment or to engage in any other transaction.
Foreign exchange transactions can be highly risky, and losses may occur in short periods of time if there is an adverse movement of exchange rates. Exchange rates can be highly volatile and are impacted by numerous economic, political and social factors, as well as supply and demand and governmental intervention, control and adjustments. Investments in financial instruments carry significant risk, including the possible loss of the principal amount invested. Before entering any foreign exchange transaction, you should obtain advice from your own tax, financial, legal and other advisors, and only make investment decisions on the basis of your own objectives, experience and resources.