How hidden costs impact hedging decisions
For the first time in over a decade, the Federal Reserve is on a path to consistently increasing rates from ultra-low levels. The market has also finally caught up with the Fed’s desire to do so as we have seen a steady rise in medium-term swap rates. As companies cope with increased future financing costs, treasury teams have returned to interest rate hedging as a risk mitigation tool. With any derivatives use, though, 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. For most companies, the visible cost of hedging is felt fully in the form of the carry cost (difference between the swap rate and 1 or 3-month LIBOR 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, the
se 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.
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 US 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.
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 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 to 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.
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.
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 http://www.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.
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About the Author
Amol Dhargalkar is a Managing Director and member of Chatham’s Operating Committee. He leads the Global Corporate Sector serving public and private corporations focusing on interest rate, foreign currency and commodity risk management. He joined Chatham in 2001 and launched its Corporate Sector offerings in 2007. Amol has advised a broad spectrum of public and privately held companies as well as corporate private equity sponsors on the structuring, implementation, and accounting of their risk management programs totaling more than US $500 billion in hedged notional. Amol graduated from Pennsylvania State University with a BS in Chemical Engineering and a BS in Economics. He also received his MBA from The Wharton School at the University of Pennsylvania where he was a Palmer Scholar.More Content by Amol Dhargalkar