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Hedging solutions

Financial Hedging Solutions & Derivatives Explained

Below we have set out explanations of some of the more commonly used hedging products for interest rates, foreign exchange and commodities.

Interest Rate Swap

Vanilla interest rate protection that fixes funding costs.

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Innovative solutions

Interest Rate Swap


What is an Interest Rate Swap?

An Interest Rate Swap is a contractual agreement between two counterparties, the Borrower and the Bank, to exchange interest payments on a pre-agreed profile. The Borrower agrees to pay a pre-agreed fixed rate of interest in return for receiving a floating rate that matches the loan (i.e. three month LIBOR) from the Bank. In most cases, the Bank counterparty will also be the Lender.

Product_notes_1

Objectives

The purpose of the Swap is to fix the cost of finance for a Borrower who has floating rate borrowings, thus protecting them from precipitate increases in short-term interest rates.

How does it work?

The Borrower will have entered into a contract to exchange a floating rate of interest for a fixed rate of interest. If the floating rate is set above the fixed rate at the beginning of a three month period, the Bank will make a net payment to the Borrower equal to the difference between the fixed rate and the floating rate, and if below, the Borrower will make a net payment to the Bank. The result is that the effective cost of funds will remain at the contracted fixed rate no matter where the floating rate fixes. 

Advantages

No upfront premium is payable.
It provides the Borrower with a pre-agreed fixed rate of interest and therefore certainty of cash flow.

Disadvantages

The effective cost of finance is fixed and therefore the Borrower cannot benefit if the floating rate is lower than the fixed rate at any time during the term of the contract.
Early termination costs are rate sensitive and may be unpalatable if prevailing market interest rates at the time of termination are significantly below the fixed rate of the swap for the remaining term. 
 

Interest Rate Swap example  

 

Interest_Rate_Swap

 

Interest-Rate-Swap-table

Interest Rate Cap

Protects against rising interest rates but allows borrower to benefit if rates fall.

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Innovative solutions

Interest Rate Cap


What is an Interest Rate cap?

An Interest Rate Cap is a contractual agreement between two counterparties, the Borrower, which is the buyer, and the Bank, which is the seller. The Bank agrees to insure the Borrower against a rise in the floating rate of interest (i.e. three month LIBOR) above an agreed strike rate. In exchange for the Cap, the Borrower is required to pay a cash premium to the Bank, usually upfront.

Objectives

The purpose of the Cap is to establish a maximum cost of finance for the Borrower that has floating rate borrowings. This will enable the Borrower to enjoy the benefit of low short-term interest rates until such time as they rise above the pre-agreed Cap strike rate.

How does it work?

On each three monthly reset date, the Cap strike rate will be compared with the contracted floating rate. If the relevant floating rate is equal to or below the Cap strike rate, no payment will be made. However, ift he contracted floating rate is above the Cap strike rate, the Bank will pay the Borrower the difference between the floating rate and the strike rate of the Cap.

Interest-Rate-Cap-table


Advantages

It provides the Borrower with a pre-agreed maximum rate of interest
It provides the Borrower with the flexibility to benefit from low floating rates, should they be lower than the Cap strike.
There are no additional costs arising on early termination. The Borrower will be entitled to receive any residual value attributable to the Cap.

Disadvantages

The Borrower will incur a premium cost, usually paid up front.
If the floating rate fails to rise above the Cap strike rate during the tenor of the Cap, the Borrower may feel that no value was received.


Interest-Rate-Cap-table1


Interest-Rate-Cap-graph

Interest Rate Swap and Floor

A synthetic interest rate cap.

 
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Innovative solutions

Interest Rate Swap and Floor


What is an Interest Rate Swap and Floor?

An Interest Swap and Floor is a combination of an Interest Rate Swap with the purchase of an Interest Rate Floor. By entering into the Swap, the Borrower agrees to pay a pre-agreed fixed rate of interest in return for receiving a floating rate that matches the loan (i.e. three month LIBOR) from the Bank. By purchasing a Floor, the Borrower acquires the flexibility to benefit if the floating rate is below the Floor strike rate. The premium for the Floor is embedded into the Swap rate so there is no upfront cash premium.

Objectives

The purpose of an Interest Rate Swap and Floor is to restore some of the opportunity for the Borrower to benefit from a low interest rate environment, and to limit the potential penalty cost that could arise on early termination when interest rates are lower than at inception.

How does it work?

The floating rate will be reset on each payment date.  If on any of those dates the floating rate is higher than the embedded Swap rate, the Bank will pay the difference between the swap rate and the floating rate to the Borrower. If the floating rate is lower than the embedded Swap rate, the Borrower will pay the difference to the Bank; however, if the floating rate is lower than the Floor strike rate, the Bank will offset, against this payment, the difference between the Floor strike rate and the floating rate.

Interest-Rate-Swap-Floor_6


Advantages

It provides the Borrower with the comfort of a known maximum rate of interest.
It allows the Borrower limited opportunity to benefit from low short-term interest rates should they fall below the strike rate of the Floor.
It enables the Borrower to restrict the potential penalty costs arising on early termination, being the difference between the Swap rate and the Floor strike rate. 
No upfront cash premium is required.

Disadvantages

Early termination costs are rate sensitive and may be unpalatable if prevailing market interest rates at the time of termination are significantly below the fixed rate of the swap for the remaining term.
 

Interest-Rate-Swap-and-Floor-table1

 

Participating Forward example  

 

Interest-Rate-Swap-and-Floor-graph

Participating Interest Rate Swap

A combination of swap and cap, combining fixed rate protection and flexibility.

Participating-Interest-Rate-SwapInnovative solutions
Innovative solutions

Participating Interest Rate Swap


What is a Participating Swap?

A Participating Swap is a contractual agreement between two counterparties, the Borrower and the Bank, to exchange interest payments on a pre-agreed profile. It is constructed by the combination of an interest rate Swap and an interest rate Cap where a pre-agreed portion of the notional amount is hedged with a Swap and the remaining portion is hedged with a Cap. The degree of participation is determined by the proportion attributable to the Cap and the instrument is rendered zero cost by embedding the Cap premium into the Swap rate. The instrument is structured in such a way that the embedded Swap rate and the Cap strike rate are set at the same level.

Objectives

To provide the Borrower with protection, at a maximum rate, against rising short-term interest rates but retain the opportunity for the Borrower benefit in a low short-term interest rate environment on the capped portion (the participation).

How does it work?

If, on any reset date, the floating rate (i.e. three month LIBOR) is below the fixed rate, then the Borrower will pay the fixed rate of interest in return for a floating rate of interest on the portion covered by the Swap. On the capped portion, the Borrower will pay the floating rate subject to a maximum determined by the Cap.  If the floating rate is above the fixed rate (strike rate), the Borrower receives the difference between the fixed rate and the floating rate on both the swapped and capped portions of the debt, ensuring a maximum cost of funds as the fixed rate (strike rate) of the Participating Swap.

Participating-Interest-Rate-Swap

Advantages

It provides the Borrower with the comfort of a known maximum rate of interest on 100% of the hedged debt.
It provides flexibility to benefit from low prevailing floating rates on the capped portion of the debt.
It provides the Borrower with greater flexibility in managing cash flows.
No upfront premium is payable.

Disadvantages

A Participating Swap Rate will be higher than the market swap rate.
If the floating rate fails to rise above the Cap strike rate during the tenor of the Cap, the Borrower may feel that no value was received.
Potential termination costs are payable on the swapped portion of the debt should the hedging be terminated early in a low rate environment
 

 

Participating-Interest-Rate-Swap-table


Participating-Interest-Rate-Swap-graph

Interest Rate Swaption

Offers the right – but not the obligation – to enter into a swap at a pre-agreed rate in the future.

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Innovative solutions

Interest Rate Swaption


What is an Interest Rate Swaption?

An Interest Rate Swaption is an option which provides the Borrower with the right but not the obligation to enter into an Interest Rate Swap on an agreed date(s) in the future. If exercised, the Borrower is entitled to enter into the Swap on the terms protected by the Swaption. 

 
A Swaption provides protection for a Borrower as it ensures a maximum fixed rate payable in the future. Furthermore, it gives flexibility if the fixed rate does not rise to the Swaption strike rate at expiry - in this case, it will not be exercised and the borrower can take advantage of the lower market rates at that time. 
 
Purpose

The Swaption enables a Borrower to protect the costs of borrowing in the future in a manner that does not involve a commitment on the part of the Borrower. If the hedge is no longer required on the future date, the Borrower will not be exposed to potential hedge termination costs.
 
How does it work?

In return for paying a premium, the Borrower acquires the option to enter into a Swap at a pre-agreed fixed rate (strike rate) on a pre-determined future date(s). If, on the exercise date, the market swap rate is higher than the Swaption strike rate, the Borrower would exercise the option and enter into the pre-determined Swap.  Should the Borrower not wish to enter into the pre-determined Swap then they can sell the Swaption and realise the monetary value.  Should the market rate be lower than the Swaption strike rate on the exercise date, the Borrower will not exercise the Swaption. 
 

Interest-Rate-Swaption

 
Advantages    
                                  
It provides the Borrower with a pre-agreed maximum rate of interest from a future date. 
It provides the Borrower with the flexibility to benefit from low floating rates prior to exercise date of Swaption.
There are no additional costs arising on early termination. The Borrower will be entitled to receive any residual value attributable to the Swaption. 
The Borrower is not obliged to enter into the Swap if interest rates should fall instead of rise. 
The Borrower is not obliged to enter into the Swap if it is no longer required. 
 
Disadvantages
 
The Borrower will incur a premium cost, usually paid up front.  
If the market rate fails to rise above the Swaption rate during the tenor of the Swaption, the Swaption will expire worthless and the Borrower may feel that no value was received. 


Interest-Rate-Swaption-table


Types of Swaptions

There are a number of different types of swaptions that can be used to protect against rising short term interest rates:

A European Swaption grants the holder the right to enter into the swap only on the expiration date (exercise date) of the option.

A Bermudan Swaption enables the holder the right to enter into the swap on a number of predetermined exercise dates. 

 

Interest-Rate-Swaption-graph

Cancellable Swap

A Swap that may be cancelled by the Borrower at no cost on an agreed date in the future.

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Cancellable Swap

What is a Cancellable Swap?

It is a Swap that may be cancelled by the Borrower at no cost on an agreed date in the future.   It is structured as a combination of an Interest Rate Swap and a Receiver’s Swaption, where the cost of the Swaption is embedded into the fixed rate of the Swap and the Swaption’s strike is chosen such that it is the same as this fixed rate.

 
Objectives

It enables the Borrower to protect their borrowing costs for a defined period of time whilst retaining the opportunity to cancel the contract on an agreed date or dates in the future without the potential burden of penalty costs. It is particularly useful if the Borrower anticipates an early termination of the underlying Loan.
 
How does it work?

The Borrower has a contractual requirement to pay a fixed rate of interest and receive the floating rate (i.e. three month LIBOR) under the Swap. The Receiver’s Swaption provides the Borrower with the option to enter into a Receiver’s Swap (receive the fixed rate and pay the floating rate) to negate the effect of the Payer’s Swap thus enabling the whole structure to be terminated at no cost to the Borrower.
 

Cancellable-Swap

 
Advantages    
                                 
It provides the Borrower with a known fixed rate of interest.
It provides the Borrower with the opportunity to cancel the contract on a future date at no cost.
No upfront cash premium is required.
 
Disadvantages
 
The fixed rate for a Cancellable Swap will be higher than that for a comparable (vanilla) Interest Rate Swap


Cancellable-Swap-table

Cancellable Swap example

 

Cancellable-Swap-image

Interest Rate Collar

Protects against higher rates while allowing borrower limited flexibility to benefit from lower ones.

Innovative solutions
Innovative solutions

Interest Rate Collar


What is an Interest Rate Collar?
 
An Interest Rate Collar is a contractual agreement between two counterparties, the Borrower and the Bank. 
 
It is a combination structure involving the effective purchase of an Interest Rate Cap and the simultaneous sale of an Interest Rate Floor.  Typically, the premium of the cap is designed to exactly match that of the floor, with the result that they cancel each other out and produce a Zero Cost Collar.
 
Objectives

For a Borrower who enters into a Zero Cost Collar, a known maximum interest rate payable (Cap strike rate) will be established at the cost of agreeing to pay a known minimum rate (Floor strike rate).  Between those two levels, the cost of finance will remain on a floating rate basis over the agreed period of time.
 
How does it work?

On each three monthly reset date, the Cap and Floor strike rates will be compared with the contracted floating rate. If the relevant floating rate is equal to or below the Cap strike rate, while simultaneously being equal to or above the Floor Strike rate, no payment will be made. 
If the relevant floating rate is above the Cap strike, the Bank will pay the Borrower the difference for the three month period. 
If the relevant floating rate is below the Floor strike, the Borrower will pay the Bank the difference for the three month period. 
 

Interest-Rate-Collar1

 
Advantages

It provides the Borrower with a pre-agreed maximum rate of interest.
It provides the Borrower with the flexibility to benefit from low floating rates down to the minimum floor level. 
Unlike a Cap, a Collar can be structured such that there is no upfront premium cost. 
 
Disadvantages
 
There may be additional costs arising on early termination due to the Borrower having to buy back the Floor. The Borrower will, however, be entitled to receive any residual value attributable to the Cap. 
If the floating rate fails to rise above the Cap strike rate and / or remains below the Floor strike rate during the tenor of the Collar, the Borrower may feel that no value was received. 

 

Interest-Rate-Collar-table


Participating forward example
 

Interest-Rate-Collar-Graph

Commodity Call Option

Protects the holder from higher prices while maintaining the ability to benefit from lower ones.

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Innovative solutions

Commodity Call Option


What is a Commodity Option?

A Commodity Call Option is a contract that grants the Consumer the right but the not the obligation to buy a specified quantity of a specified commodity from the Producer, at a fixed price, on a stated future date.
 
Objectives

The purpose of a Commodity Call Option is to place a maximum cost on a known future purchase of a commodity. It thereby limits the downside cost while maintaining the ability to purchase at a lower rate if it occurs.
 
How does it work?
 
An oil consumer knows they will need to purchase 500 barrels of Brent crude in a year’s time. They do not want to pay more than $105 per barrel and do not want to pay for storage. Therefore they buy a call option with a strike of $105, which means that if oil prices are above this level, they exercise the option and only pay $105 per barrel. If the price is below the strike, (e.g. $100) they can allow the option to expire worthless and buy their barrels at the market rate.
 
Commodity-Call-Option
 
Advantages  

Provides the Consumer with a maximum cost.
Provides the Consumer with the flexibility to benefit from low fuel rates should the spot price be lower than the Option strike at expiry. 
 
Disadvantages

Consumer will incur a premium cost, usually paid up-front 
If fuel rates fail to rise above the Option strike rate during the tenor of the option, the Consumer may feel no value was received, as the option will expire worthless.


Commodity-Call-Option-table


Participating Forward example

Commodity-Call-Option-graph

Commodity Put Option

Protects the holder from lower prices while retaining the ability to benefit from higher ones.

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Innovative solutions

Commodity Put Option


What is a Commodity Put Option?
 
A Commodity Put Option is a contract that grants the Producer the right but not the obligation to sell a specified quantity of a specified commodity to the Consumer, at a fixed price, on a stated future date.
 
Objective

The purpose of a Commodity Put Option is to place a minimum payment receipt on a known future sale of a commodity. It thereby limits the downside risk while maintaining the ability to trade at a higher spot rate if it occurs.
 
How does it work?
 
An oil Company knows they will have produced 500 barrels of oil in a year’s time. They do not want to pay for storage longer than necessary, but do not want to sell the oil for less than $105 a barrel. Therefore they buy a put option with a strike of $105, which means that if prices are below this level they will exercise the option and have the right to sell oil at $105 per barrel. But if the price is above the strike, (e.g. $108) they can allow the option to expire worthless and sell their barrels at the market rate.
 

Commodity-Put-Option

 
Advantages

Provides the Producer with a minimum income 
Provides the Producer with the flexibility to benefit from high fuel rates should the spot price be higher than the Option strike at expiry.
 
Disadvantages

Holder will incur a premium cost, usually paid up-front
If fuel rates rise above the Option strike rate during the tenor of the option, the Producer may feel no value was received, as the option, the Producer may feel no value was received, as the option will expire worthless.


Commodity-Put-Option-table


Participating Forward example

Commodity-Put-Option-graph

FX Forward

Vanilla protection against an adverse FX movement.

Innovative solutions
Innovative solutions

FX Forward


What is an FX Forward?
 
An FX Forward is a contractual agreement between two counterparties, the client and the bank, or other non-bank provider, to exchange physical amounts in different currencies at a single set date in the future and at a set rate. A forward transaction differs from a spot transaction in the length of time between the trade date (the day the transaction is confirmed between the counterparties) and the day of settlement (when the currency is actually exchanged); the settlement, or maturity, date is also known as the value date. Settlement for most spot trades is T+2 (two business days after the trade date), whereas for forward trades settlement is anything greater than this.
 
Objective

The purpose of an FX Forward is to lock in the current exchange rate between two currencies at a set date in the future. This might be done, for instance, if a company is contractually obliged to pay a set amount for the future delivery of goods in a foreign currency, and wishes to lock in the current exchange rate.
 
How does it work?
 
The two counterparties will look at the forward rates derived from the spot market and any negotiation will be over the spread the bank will take outside these projected forward rates. The FX Forward rate between two currencies will be different from the spot rate. However, the forward rate is directly derived from the spot rate in the form of an arithmetic adjustment to the spot rate based on the interest rate differential between the two currencies. The provider will also take a spread that will increase for trades of non-market size, whether small or large, and for the credit utilisation and liquidity risk of trading into the future. 
 
Advantages

Provides total certainty over the rate of exchange in the future.
A forward is an OTC (Over The Counter) instrument and can therefore be tailored to the exact requirements of the client as far as quantum and tenor are concerned.
 
Disadvantages

Inflexible compared to options as it does not allow the client to benefit from advantageous movements in prices.
Some sort of credit line is always required, whether ‘margined’ or ‘clean’, i.e. with or without the need for margin payments.
Should the market move against the client, in the absence of a clean credit line, margin requirements by a bank or broker could force a client to post large quantities of collateral, adversely impacting the client’s cash flow.
 
FX Forward example

FX-Forward

FX Swap/Rollover

Facilitates the lengthening or shortening of an FX forward.

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Innovative solutions

Interest Rate Swap


What is an FX Swap/Rollover?

An FX Swap (or rollover) is an FX strategy that allows the client to roll forward the actual exchange of currencies at the maturity (settlement) of a forward contract. The client pays the existing counterparty the mark to market of his current position and enters into a new forward. It is not to be confused with a cross currency swap, interest rate swap or commodity swap where there is a series of exchanges. 

 
Objective

To allow the maturity date of a forward contract to be pushed forward (or brought back).
 
How does it work?

For example, a USD-based client intends to sell an asset in Europe in a year’s time and on completion of the sale will need to then sell EUR for USD. The client wishes to protect the current forward rate of 1.0950 and therefore enters into a forward contract at this rate to sell EUR and buy USD. Upon arriving at the maturity date (or, more precisely, two working days before) the client has not sold the asset and therefore has no EUR to sell. The client therefore executes an FX Swap to change the value date of his current position.
 
He buys back the EUR which he had agreed to sell under the old forward contract (which is now trading for spot value) at either a profit or a loss and simultaneously sells the EUR forward again to a new forward date by which time he is sure the sale will have gone through. Effectively, he pays or receives the mark to market of his current position and enters into a new forward contract for a month’s time when he can be sure that the sale of the asset has gone through. 
 
Advantages

Introduces flexibility to hedging using forward contracts
 
Disadvantages

Profits and losses have to be crystallised on rollover. While it is true that, from a P/L perspective, the spot rate on rollover has no effect, since what is lost on the spot leg is made up on the new forward leg, the crystallisation of a loss on the near leg of the rollover will create a funding requirement until the maturity of the far leg.  

FX Option

Protects against an adverse FX movement but allows the holder to gain from a beneficial one.

Innovative solutions
Innovative solutions

FX Option


What is an FX Option?
 
An FX Option is a contract that confers on the holder the right – but not the obligation – to exchange an amount of one currency for another at a pre-agreed rate (the ‘strike’ rate) on a pre-agreed date. 
 
Objective
 
The purpose of an FX Option is to place a maximum (or minimum) exchange rate on a known transaction of a different currency in the future, thereby limiting the potential downside but maintaining the ability to exchange at a more favourable rate should it occur.
 
How does it work?
 
A firm of UK exporters is to receive a payment of USD 10,000,000 in a year’s time. They want to protect the GBP value of the payment so that the conversion rate will be no higher than 1.3000. Therefore, they purchase a USD put/GBP call option with a strike price of 1.3000. 
 
In a year’s time, if the GBP/USD rate is above 1.3000, i.e. if the option is ‘in the money’, they can exercise the option and still exchange at 1.3000. If the rate is below 1.3000, and the option is ‘out of the money’, they can enter the market at the advantageous spot rate, letting the option expire worthless.
 
Advantages
 
Provides the holder with a pre-agreed worst-case exchange rate.
Provides the holder with the flexibility to benefit from a lower exchange rate, should the spot rate be lower than the option strike at expiry.
Requires only a minimal two-day credit line between purchase of, and payment for, the option.
The holder has no obligation.
 
Disadvantages
 
The holder will incur a premium cost, usually paid up front.
If the option expires ‘out of the money’, no value will be received. The option will expire worthless, similar to an insurance contract.
 
Trade description

FX-Option

FX Option scenarios

 

FX-Option-1

FX-Option-graph

FX Collar

Protects against an adverse FX movement while maintaining limited ability to gain from a beneficial one.

Innovative solutions
Innovative solutions

FX Collar


What is an FX Collar?
 
An FX Collar is a combination structure that involves buying a protective, out of the money option and simultaneously selling another out of the money option on the same notional amount, but with opposite polarity.
 
Objective

The purpose of an FX Collar is to provide both a maximum and minimum exchange rate which the holder can pay, but to allow flexibility to benefit from the market rate in between.
 
How does it work?

A UK firm of exporters will be receiving USD 10,000,000 in a year’s time. They want to enter into a hedging contract to protect the conversion rate, so they buy a USD put/GBP call option. However, they do not want to pay a premium so they offset that by selling a USD call/GBP put option with a strike so that the premium is equal to that of the bought USD put option. The result is that the USD put option has limited the risk of USD depreciation, but the sold USD call option has limited the ability to benefit from USD appreciation.
 
Advantages

No upfront premium.
Offers protection above the strike of the bought USD put.
Allows benefit of lower market rate down to the strike price of the sold USD put.
 
Disadvantages

Limits ability to benefit from USD appreciation.
Protected rate is above what could be achieved using a forward.
Termination could incur extra costs depending on the market rate at that time.
 
Trade description

 

FX_Collar


FX-Collar-2

FX Collar scenarios

FX-Collar-3

FX-Collar-graph

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