Missing the boat: when is it too late to start hedging?

AuthorOkochi, Jiro

With the steady decline of the U.S. dollar (USD) since the summer of 2003, the gradual rise in short term interest rates and the painful rise of commodities prices, many treasurers are revisiting their hedging strategies and policies. Is it too late to start hedging against these moves or, as the saying goes: "Are they a day late and a dollar short?"

Now, it would not have taken a Warren Buffett or George Soros to figure out that one day interest rates might rise and that the U.S. dollar was heading for a decline because of the ever-widening U.S. trade deficit. So for the most part, it's not that treasurers missed an opportunity to hedge, but often exposures are not understood until it is too late, which may result in an unpleasant surprise to report at the end of the quarter.

Let's start with the common gauge for interest rate exposure and the measurement of the fix-float mix for corporate liability management. It follows a good rule of keeping it simple, with a single percentage describing the relative exposure to changing interest rates--with 100 percent being completely fixed and not exposed to rising rates, and zero percent being completely floating and perhaps enjoying the benefits of low interest expense.

Companies can set hedging and issuance guidelines around this number that can be clearly and easily communicated. It's also nice because you can chose to use swaps to get you to your target mix if your comparative advantage for issuance does not suit your fix-float goal.

The problems with just using this number as your only measure is that it does not capture the duration of your liabilities and it looks just at the liability side, as most corporate treasuries do not have financial assets that bear fixed or floating coupons. For non-USD issuers, there is also noise from the underlying foreign exchange (Fx) exposures unless everything is swapped back to USD fixed or floating via cross-currency swaps.

To illustrate this point, say a company decided to change its fix-float mix from 50/50 in 2003 to 100 percent at the start of 2004. The company did not have a risk management policy that allowed for interest rate swaps, since it was typically able to issue fixed via the capital markets. However, if its long-term rating declined or the supply of fixed-rate corporate debt flooded the market, the company may be better forced to borrow at floating rates. The company now has to make operational changes to be able to enter into swaps, like...

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