The ups and downs of interest rate hedging

After a long period of stability, we are currently experiencing an exceptional rise in interest rates. For many involved in Treasury this is a new world. We examine the impact of interest rate volatility and what we should now be paying attention to as inflation fuels global interest rate risk.

by | September 8, 2022 | Hedgebook

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As a young treasurer in the 1990’s, managing interest rate risks was as much of a focus as moving foreign exchange rates. The impact of high interest rates on FX forward points was significant – as they were on the general economic outlook.

At the time, a high interest rate environment was all we knew. Just as the new breed of treasurer coming through has only ever experienced low interest rates. They have not had to consider what a lift in rates might mean for the company and hedging performance. Until now.

Fuelling interest rate rises

After more than a decade of interest rate declines, the recent reversal has been rapid. Pent-up consumer demand following two years of off-and-on Covid-induced lockdowns, fuelled by cheap money, has contributed to inflation rates not seen for decades.

The Russian war in Ukraine has led to inflation on the supply side, particularly around energy. Attempts to reduce reliance on Russian oil and gas has had a knock-on effect on food and energy prices – leading to the cost-of-living crises in many parts of the world. Naturally, workers are asking employers for wage increases to compensate, which in turn risks pushing inflation rates even higher.

Central banks are now in catch-up mode, reaching into their (arguably limited) tool kit to try and rein in inflation. Base lending rates are increasing sharply, which has the dual effect of curtailing consumer demand through less disposable income while incentivising people to keep their money in the bank.

Those with mortgages and other forms of debt will feel the impact of higher interest rates as mortgages roll off their fixed rate period and reset at the higher market rate. Borrowers on floating rates will feel the effects sooner. Meanwhile, savers are rewarded with higher interest rates, which means less consumer-led demand and a reduced contribution to upward pressure on prices.

Forward points are now in play

For those running foreign exchange risks, this changing interest rate environment has not only added to recent volatility, but has also brought the forward point differential into play.

As FX forward points are derived from the difference between the two underlying interest rates of an FX transaction (i.e., the buy currency’s interest rates versus the sell currency’s interest rate), the requirement to manage this aspect has increased.

For those buying a high interest rate currency, there is a benefit to taking longer-term cover given the improvement in the forward rate versus the spot rate. Equally, if you are selling a high interest rate currency, there is a cost to selling into the future. These organisations often have a much shorter-term hedging horizon and leave much more of their exposure to the vagaries of the spot market.

Mark to market valuations

Another impact of higher interest rates has been on the mark to market valuations of hedging already in place, especially for interest rate swaps. The movement higher means the valuations of existing borrower interest rate swaps (pay fixed/receive floating) will be looking a lot healthier than they did 12 months ago. This is because the floating leg of the swap is receiving a much higher interest rate, offsetting the pay-fixed leg of the swap.

Interest rate swaps are often long-dated instruments with maturities out to 10 years and beyond. Many swaps entered a few years ago have looked quite sick in recent years with large negative valuations. The rapid rise in interest rates, to combat the inflation pressures, has led to the reduction in these negative valuations.

It is also worth noting that as these financial instruments become less of a liability and, indeed, an asset, then there are consequences for CVA/DVA calculations.

Impact of Libor transition

Adding to the treasurer’s angst has been the recent cessation of Libor, the primary index for the floating leg of pound sterling (GBP) and US dollar (USD) interest rate swaps. Following its cessation, the index will be replaced with Sonia for GBP and SOFR for the USD. This has created some confusion when it comes to valuations, as witnessed by the queries we have fielded from our auditor users.

When valuing a GBP interest rate swap at a valuation date beyond December 31, 2021, it is important to use the Sonia zero curve as there is a material difference for the implied future floating legs and discount factors between a Libor and Sonia curve. If a swap is valued using the Libor curve but is compared to a third-party valuation e.g., a bank valuation, the valuations will likely not align.

So, no more feet on the desk for those tasked with managing their organisation’s interest rate risks. The question now for treasury teams is where to from here?

As always there is a balancing act between interest cost certainty and interest cost.  Time to find a better solution than that crystal ball.




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