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Pre-Hedging Rates

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In the second Monetary Policy Committee review of the year, the Bank of England held rates at their current 0.5% level amid lower-than-expected inflation figures (CPI inflation in the UK fell from 3.0% in January to 2.7% in February) and only modest improvements to wage increases. However, policymakers Ian McCafferty and Michael Saunders said economic conditions were sufficient enough to justify a 0.25% rate increase, which would be only the second time since the financial crisis a decade ago. Governor Carney was also hawkish in the first meeting of 2018 stating "…monetary policy would need to be tightened somewhat earlier and by a somewhat greater extent over the forecast period". This was accompanied by a 9-0 vote to hold rates versus the more recent, again more hawkish, 7-2 vote in favour of holding rates. Consequently many market commentators are revising their prediction for the next rate hike from August to May 2018.   
 
Last week saw Jay Powell preside over his first Federal Reserve meeting as chair. As was largely anticipated, the Fed lifted the federal funds rate (what banks charge each other for overnight loans) by a quarter point to a range of 1.5% to 1.75%. The meeting was generally seen as hawkish and was accompanied by the dot plot predictions for 2019 and 2020 moving higher than the previous rate hike meeting in Dec 2017. However, the Fed maintained its forecast for a total of three hikes this year, amid still-modest inflation, whilst raising its projection from two to three hikes next year as inflation picks up. With federal tax cuts and increased spending announced since the last Fed hike set to spur growth over the next couple of years, some analysts anticipate policymakers’ median projection to factor in an additional hike in 2018.
 
Against this shifting central bank policy backdrop, and after a decade of exceptional monetary accommodation, any investors seeking leverage in the current environment should be considering their hedging options closely. One such solution to mitigate risk that has been gaining traction across asset classes and risk type (FX, interest rate, inflation) is deal-contingent hedging. Deal-contingent hedging has, for a number of years, been deployed as an effective risk mitigation solution in cross-border M&A transactions where there has been a sizable foreign exchange exposure. A deal-contingent hedge makes it possible to lock in the cost of an acquisition in the purchase currency and have no costs if the transaction does not complete.
 
Within the increasingly competitive project finance market, deal-contingent hedges are playing a vital role in managing interest rate, foreign exchange and inflation rate risk particularly where financial close is not anticipated for several months. We see deal-contingent hedges being used especially in bid situations where suppliers are asked to bid fixed prices at which they are prepared to supply a commodity (such as electricity), and once awarded the offtake contract, have several years to reach commercial operation. Often such projects have high LTV (70%+), large FX risk (80%+ of capex) and an inflation linked income over a long consideration. The deal-contingent hedge enables sponsors to bid for projects with the financial risks known or mitigated thereby locking down the project’s returns.
 
Sponsors with a sufficiently large balance sheet and/or cash or applicable instruments available as margin/collateral, may choose to use forward-starting swaps to lock in rates. However, such swaps are not always available in the current regulatory environment to credit constrained entities. The deal-contingent hedge also has the advantage over a forward-starting swap in that if financial close does not occur, then the forward-starting hedge would require a termination payment (or gain) as it is unwound.
 
Deal-contingent hedging can be complicated by accounting under the main accounting standards. As a derivative, its changes in mark-to-market will have to be recorded into the income statement, unless hedge accounting can be applied to it. In practice, we are seeing different views amongst audit firms when it comes to the feasibility of hedge accounting for this type of instrument, so seeking advice on the issue and not downplaying the accounting impacts of such transactions is recommended.
 
Notwithstanding these considerations to deal-contingent hedging, we encourage clients to contemplate their future hedging requirements, especially in light of a rate landscape that looks increasingly less accommodative and more volatile than the past decade.
 

All views expressed here are the Author’s own and are based on information available at the time of writing

 

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