Bancorp Treasury Services Limited

Make Risk Count.

DON’T BET THE RANCH WHEN PLANNING YOUR INTEREST RATE STRATEGY

01 September 2010

It’s easy to be beguiled by predictions that interest rates have bottomed out, particularly when borrowing money or re-structuring loans. Hedging financial risk by using interest rates swaps is a sound strategy, particularly in these volatile times. But as with any treasury risk management strategy, it is important to consider all eventualities and put measures in place to mitigate any potential threats that could arise from using swaps.

Interest rate swaps involve exchanging one set of cash flows for another over an agreed period so as to provide the assurance of long-term fixed loan interest costs. The most common type of interest rate swap involves exchanging floating rate cash flows for fixed ones. (Floating involves the interest rate being re-set regularly, which is the case with most bank loans.)

Some businesses may have been tempted recently to load up their swaps hedging after some forecasters predicted that interest rates would soon begin to climb. Before taking any action, it’s important to remember that forecasters have little success accurately predicting market directions, let alone actual rates! It’s also important to realise that while the Reserve Bank controls the Official Cash Rate, changes to longer term rates depend on the markets, including those overseas and especially in the US.

Some swap rates have fallen a full percentage point since predictions a few weeks ago that they had bottomed out. There’s a chance they could continue to fall further, even if the Official Cash Rate goes up. That’s what happened in Australia (as highlighted in the accompanying graph). Conversely there’s a chance they could begin to climb again. Nobody knows for sure. The economic mood is looking rather pessimistic again, as this week’s NZIER Quarterly Predictions and the National Bank’s Business Outlook survey both reveal.

Rather than leaping at what appears to be a great interest rate opportunity, businesses should look beyond today’s rates and adopt a disciplined approach to markets management by taking steps to minimise risks when using swaps.

It’s all very well fixing interest rates but don’t bet the ranch by locking up all your planned exposure for a long period. What if your underlying numbers change? Being over-hedged is often worse than being under-hedged. You have to allow for different scenarios. It’s better to build a swaps portfolio in a piece by piece manner that avoids the inherent risks of making a big call on the ‘ideal’ rate.

Potential risks associated with swaps can be mitigated by using them with options. If you firmly believe interest rates have hit the bottom and are set on taking as much cover as possible, at least do it using options, which give you an escape route if you are wrong. For example, a cap protects against rising rates but allows you to benefit from falling rates.

Other techniques include buying a swaption (an option to enter into an interest rate swap at a later date at an agreed rate), or entering into an interest rate swap that only takes effect at some point in the future, maybe one or two years hence. The structure can be tailored to suit your specific needs.

Although using swaps can, like other risk management tools, carry some pitfalls, routinely using swaps is good for borrowers and investors alike when used prudently. As always, be sure to understand a product before using it.

Using swaps is a sign of market sophistication, and developed economies depend upon them as part of their wider financial market landscape. The key is for businesses to ensure their swaps are appropriate for their business or industry.

Ultimately the best strategy is to base decisions on the degree of commitment to the swaps themselves, rather than purely on interest rates.

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