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Banking Essentials - Part I

This pathway will walk us through the basics of banks, starting with some of the different types and their main functions, then starting to look at the regulation faced by the banks, both before and after the Global Financial Crisis.

Greenwashing

Greenwashing is the act of distributing false information about something being more environmentally friendly than it actually is.

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Tackling the Cost of Living Crisis

In this video, Max discusses the cost-of-living crisis currently enveloping the UK. He examines its impact on households as well as the overall economy.

CSR and Sustainability in Financial Services

In the first video of this two-part video series, Elisa introduces us to sustainability. She begins by looking at the difference between sustainability and corporate social responsibility, two terms that can be easily confused.

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Contingent Interest Rate Hedges

Contingent Interest Rate Hedges

Selim Toker

30 years: Derivatives & risk management

In this video, Selim has explained the context in which rate risk arises in event-driven transactions, and discussed the factors that will drive the pricing of a deal contingent hedge to eliminate this risk. He further examined the reasons why the pricing might differ from an FX DC.

In this video, Selim has explained the context in which rate risk arises in event-driven transactions, and discussed the factors that will drive the pricing of a deal contingent hedge to eliminate this risk. He further examined the reasons why the pricing might differ from an FX DC.

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Contingent Interest Rate Hedges

9 mins 31 secs

Key learning objectives:

  • Understand the situations in which interest rate DCs are an appropriate hedging strategy

  • Identify the drivers of the IRDC product pricing

Overview:

Deal contingent transactions allow a buyer to hedge market risks that arise between the signing and closing of a transaction. The risk is mitigated by the fact that if the transaction fails to close when conditions precedent are not met, then the hedging trade will disappear at no cost to the buyer. This video will examine how interest risk arises in event-driven deals and also the factors that drive the pricing of the IRDC product.

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Summary

Interest Rate Risk Management

Rate risk arises in an event driven transaction when there is a debt / financing element to the deal. As the steady state financing structure will only be set once the deal has closed, IRDCs can be put in place at signing to immunise against rate rises between signing and closing.

  • An IRDC is typically a forward-starting pay fixed, receive floating swap, with a clause that will cause the swap to terminate at zero cost if the conditions precedent in the deal are not met
  • If the swap is hedging future fixed-rate financing that will be launched at closing, then the swap will be unwound at launch, and the positive PV will offset the higher coupons of the new debt should rates have risen
  • If the buyer on the other hand already has floating rate financing in place and wishes to swap it to fixed for ALM purposes, then the IRDC swap will simply stay in place and act as the ALM hedge

Cross-currency swap DCs can also be used to the extent that the financing is not in the desired currency of debt, due to cost or liquidity considerations.

Risk and Cost Considerations

The level of interest rates will typically be an input into any pricing model that is used to come up with a bid price for a project. If the interest rate is left floating, then the market standard would be to input the current floating rate plus a 25bp buffer. Therefore locking in the interest rate would allow bidders to one less stress factor in the model and ultimately a more compelling bid price. This is why IRDCs are relatively common in long dated infrastructure transactions, where the interest rate becomes an important factor to an already competitive market.

IRDCs are relatively cheap given the lower volatility of interest rates versus foreign exchange. The cost is also applied to a long dated running coupon as opposed to a principle amount so the impact is lesser. Countering this however, is the fact that the conditions precedent to a successful close are often more idiosyncratic, and have longer expected timelines to fulfilment, making the DC riskier for the underwriter. There is also an increased documentation risk as often all documents are signed at closing, meaning  the DC will referenced a draft agreement for the conditions precedent. IRDCs typically trade at around 40% of the ATM option, versus around 20% for a Private Equity FX FXDC.

 

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Selim Toker

Selim Toker

After a 30-year career in Investment Banking, Selim Toker transitioned to the FinTech space and is currently the Chief Strategy Officer of incard, a digital banking and financial services platform targeting e-commerce and digital entrepreneurs. Prior to that Selim spent 17 years at UBS and 12 years at Nomura, focussed on derivatives advisory, structuring and marketing.

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