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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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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