Interest Hedging in Times of Uncertainty

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Interest Hedging in Times of Uncertainty
Annual Conference of the Croatian Association of
Corporate Treasurers, September 2009 Mag. Martina
Kranzl
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Agenda
Initial Situation
Interest Hedging in Times of Uncertainty
Basic Instruments
Participation in Money Market Rates
Participation in Capital Market Rates
Appendix
3
Agenda
Interest Hedging in Times of Uncertainty
Basic Instruments
Participation in Money Market Rates
Participation in Capital Market Rates
Appendix
4
Initial Situation

• The purpose of this material is to present you
  with ideas to control your interest rate risks.
  On this basis, further possible solutions for you
  can be discussed.
• The following example is precisely tailored to a
  specific initial situation. Modified solutions
  are naturally available for an altered initial
  situation.
• I assume the following
• The coverage of your EUR financing needs for the
  next 5 years will be met by taking out a variable
  loan based on the 3M Euribor.
• The interest rate will be stipulated at the
  beginning of every 3-month period based on the
  current 3M Euribor whereas the interest payment
  will take place in arrears on the last day of the
  respective period.
• You would like to secure yourself against an
  unlimited increase in your interest load. For
  this hedging you do not want to pay a premium.

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Agenda
Initial Situation
Basis Instruments
Participation in Money Market Rates
Participation in Capital Market Rates
Appendix
6
Current Market Environment

• A historically low interest rate environment
  prevails in the Eurozone with low capital market
  interest rates and even lower money market
  interest rates.
• On the one hand, low capital market interest
  rates offer the chance of entering into an
  attractive fixed-rate agreement.

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Current Market Environment

• On the other hand, a significant premium in the
  form of a spread will be required for this
  hedging, particularly in an economically strained
  environment.
• The 5Y swap rate is currently more than three
  times as high as the 3M Euribor (0.762).
  Therefore, more will be calculated for the
  interest hedge than for the financing (excluding
  financing margin). The interest rate difference
  between the 5Y swap rate and the 3M Euribor
  reached its 5-year high at 2.0380. (see
  appendix)
• In addition to the fact that it is quite
  unattractive to pay a substantial premium,
  particularly in a period of weak economic growth,
  a 5Y interest rate swap does not fulfill the
  requirement for flexibility.
• The 5Y swap rate exceeds the 3M Euribor because
  the financial markets expect, on average, an
  economic recovery and consequently for the ECB to
  react with a series of rate hikes in key interest
  rates in order to control inflation.

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Current Market Environment

• However, an economic recovery and a steady
  increase in money market rates is only one
  possible future scenario.The swap rate should be
  interpreted as an average of a wide range of
  market expectations (equilibrium price of supply
  and demand). It does not imply that this one
  particular possible future development will
  actually occur.
• In times of robust economic growth, the range of
  market expectations concerning the future course
  of interest rates is relatively narrow. In light
  of present day uncertainties, current
  expectations are much more diverse.
• On the next slides two extreme scenarios for
  economic development will be presented. I will
  elaborate on which form of interest rate hedging
  would meet the needs of a regular pro-cyclical
  customer.

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Interest Rate vs. Economic cycle

• It is assumed that the demands of a business
  entity will be best met if the interest payments
  on debt capital are sustainable i.e. if they
  adjust simultaneously with the economic cycle.
  This is the primary condition.
• Once the primary condition is met, we can turn
  our attention to the secondary condition a low
  rate of interest.

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Recovery Scenario

• The recovery from the recession, already presumed
  on the equity markets, continues steadily. During
  the following year, at the latest, the Eurozone
  economy will post positive growth rates.
• The positive sentiment is reflected by sharply
  rising commodity prices and expectations for a
  rapid tightening by the ECB. The 3M Euribor is
  expected to exceed the level of the current 5Y
  swap rate by the middle of next year.
• This recovery scenario makes clear that the lack
  of interest hedging would lead to a higher
  interest load and/or higher hedging costs.

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Recovery Scenario

• In a recovery scenario, an entity making use of
  an interest rate hedge would be better off due to
  two factors
• Fully hedged and immunised to increasing interest
  rates.
• No upfront premium.
• It should also be noted that a pro-cyclical
  business entity could presumably sustain these
  higher interest costs. The improvement of the
  business outlook justifies a higher interest
  load. After all, new projects would have to be
  financed at a higher level.

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Weakness Scenario

• Although many market participants anticipate an
  early recovery, some predict a much slower
  recovery and even long-term economic weakness
  cannot be excluded.
• In this scenario, the financial market continues
  to be overwhelmed by ever-increasing uncertainty
  and consumer confidence decreases further, even
  in stable economies like Germany.
• Improvements in sentiment prove to have been too
  optimistic. Many companies are put under severe
  pressure as their production capacities which
  were increased in recent years can no longer be
  exploited or sustained.
• At the same time, governments are obliged to
  reform social aid and increase tax income to
  satisfy lenders and avoid a rise in financing
  costs putting the private sector under additional
  pressure.

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Weakness Scenario

• This scenario clearly points out how essential it
  is for a company to choose a variable loan that
  adjusts to the economic cycle at least for a
  portion of the financing requirement.
• In a weakness scenario, an entity making use of
  variable financing would better off due to two
  factors
• In comparison to the swap, no premium in the
  form of a spread has to be paid to the 3M
  Euribor.
• The entity can fully participate in a further
  declining 3M Euribor.
• Therefore, at least some of the demand-side
  shocks can be buffered by lower financing costs.
• Moreover, interest management contributes to
  flexibility under the constraints of a tight
  financial situation in times of an economic
  crisis.

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Smoothing Results via Variable Financing

• Presented below is the smoothing effect of
  matching the interest costs with the development
  of the sales revenues by means of variable
  financing.
• The gross profit and operating profit (EBITDA)
  will remain unaffected by the smoothing effect of
  variable financing but the fluctuation in annual
  profit can be minimised by adjustable interest
  costs.

Bear Market Declining sales revenues absorbed by
decreasing interest costs.
Bull Market Rising interest costs compensated by
higher sales revenues.
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Interim Conclusion

• If the recovery scenario occurs, a fixed rate
  swap may well have been a reasonable solution in
  hindsight. This will not be the case with the
  weakness scenario. The possibility of retaining
  at least some sort of participation in lower
  interest rates and keeping financing costs
  flexible remains unutilized.
• This leads to two recommendations regarding
  interest hedging
• Dont miss the chance to secure a maximum
  interest rate level to take advantage of current
  low interest levels. (Hedging)
• Maintain participation in low 3M Euribor interest
  rates for as long as the economic recovery is
  delayed. (Participation)
• Below are various adjustable interest hedging
  solutions calculated with the expressed
  recommendations Hedging and Participation. All
  structures are free of premium. The following
  conditions are reference points on which a
  dialogue should be built.

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Agenda
Initial Situation
Interest Hedging in Times of Uncertainty
Participation in Money Market Rates
Participation in Capital Market Rates
Appendix
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Interest Rate Swap

• You enter into an interest rate swap which allows
  for the exchange of 3 month Euribor (3M Euribor)
  of your funding against the payment of the fixed
  interest rate of 2.8000 p.a. for the period of 5
  years.
• The 3M Euribor will be used to service the
  underlying funding this interest rate provision
  is not dependent on your funding. The fixed rate
  of 2.8000 p.a. plus your individual funding
  margin will be your total interest load of the
  swap. For the remainder of the document this will
  be your comparison rate.
• Alternative indications 2.2000 p.a. for 3
  years 3.5500 p.a. for 10 years
• Rewards fixed calculation rate, no upfront costs
• Risk no participation in low Euriborrates

3M-Euribor
3M-Euribor
Loan
2.8000 p.a.
Client
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Interest rate Cap

• Your interest load is based on the 3M Euribor and
  you want to maintain your interest load on a
  floating basis.
• You pay a premium of 2.5000 p.a. to guarantee a
  maximum interest rate on the 3M Euribor at
  3.5000 p.a. for the period of 5 years.
• Alternative indications
• Maximum interest rate at 2.7500 p.a. for 3
  years upfront premium 1.5000 of the notional
  amount
• Maximum interest rate at 5.0000 p.a. for 10
  years upfront premium 3.9000 of the notional
  amount
• Rewards full participation in low Euriborrates,
  hedge against rising interest rates
• Risk upfront costs

3M-Euribor
3M-Euribor
Loan
3M-Euribor, maximum rate 3.5000 p.a. Premium
2.5000
Client
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Agenda
Initial Situation
Interest Hedging in Times of Uncertainty
Basic Instruments
Participation in Capital Market Rates
Appendix
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Libor Factor with Cap

• Market Expectations Slightly rising or falling
  3M-Euribor.
• Term 5 Years, bullet
• Interest Mode quarterly, act/360, mod. foll.
• Customer Receives 3M-Euribor
• Customer Pays Liborfactor rate 1.25 x
  3M-Euribor
• i.a., max. 4.0000 p.a.
• Interest rate determination at the end of a
  period (in arrears)

Alt. Fixed Rate 2.8000 p.a. 3M-Euribor 0.762
p.a. Stand Still 0.9525 p.a. Savings 1.8475
p.a. Worst Case 4.0000 p.a. Best Case 0.000
p.a.
3M-Euribor
3M-Euribor
Loan
Liborfactor rate 1.25 3M-Euribor, max. 4.0000
p.a.
Client
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Libor Factor with Cap

• You enter into an interest rate swap which allows
  for the exchange of 3 month Euribor (3M Euribor)
  of your funding against the payment
  Liborfactorrate.
• The 3M Euribor will be used to service the
  underlying funding This interest rate provision
  is not dependent on your funding. The liborfactor
  rate plus your individual funding margin will be
  your total interest load of the swap.

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Libor Factor with Cap

• RISKS
• The factor of 1.25 leads to commensurately higher
  interest load.
• The maximum rate is 1.2000 p.a. higher than the
  alternative rate.
• In case of increasing Euriborrates the fixing in
  arrears leads to a higher interest rate load.
• REWARDS
• You can participate in low Euribor rates.
• You have secured a maximum rate at no upfront
  premium.
• In case of falling Euriborrates the fixing in
  arrears leads to a lower interest rate load.

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Interest Swap with Contingent Fixed Rate

• Market Expectations Slightly rising or falling
  3M-Euribor
• Term 5 Years, bullet
• Interest Mode quarterly, act/360, mod. foll.
• Customer Receives 3M-Euribor
• Customer Pays 3M-Euribor i.a.
• as long as 3M-Euribor i.a. lt 2.6000 p.a.,
• otherwise 4.7000 p.a. until the end of the
  Term
• Interest rate determination at the end of a
  period (in arrears)

Alt. Fixed Rate 2.8000 p.a. 3M-Euribor 0.762
p.a. Stand Still 0.762 p.a. Savings 2.0380
p.a. Worst Case 4.7000 p.a. Best Case 0.0000
p.a.
3M-Euribor
3M-Euribor
Loan
3M-Euribor i.a. or 4.7000 p.a.
Client
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Interest Swap with Contingent Fixed Rate

• You enter into an interest rate swap which allows
  for the exchange of the 3-month Euribor against
  the payment of the participation interest rate
  for the period of 5 years. This interest rate
  provision is not dependent on your funding. The
  participation interest rate plus your funding
  margin will be your total interest load of the
  swap.
• The participation interest rate will be the 3M
  Euribor fixed at the end of every quarter (in
  arrears), as long as the 3M Euribor in arrears is
  fixed below the level of 2.6000 p.a. If the 3M
  Euribor is fixed above the level of 2.6000 p.a.
  you have to pay the Maximum rate of 4.7000 p.a.
  for this period and the rest of the tenor.

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Interest Swap with Contingent Fixed Rate

• RISKS
• The maximum rate of 4.7000 p.a. is 1.9000 p.a.
  above the comparison rate.
• Once the 3M Euribor is fixed above the level of
  2.6000 p.a. you will pay the maximum rate of
  4.7000 p.a. for this period and the rest of the
  tenor.
• The fixing in arrears can lead to a higher
  Interest load and a sooner change into the fixed
  rate of 4.7000 p.a.
• REWARDS
• You have secured a maximum rate and therefore a
  fixed calculation basis.
• As long as the 3M Euribor is fixed below the
  interest rate level of 2.6000 p.a., you can
  fully participate in low Euriborrates.
• You do not have to pay a premium for this hedging
  instrument.

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Smooth-In Swap

• Market Expectations Falling or constant
  3M-Euribor in the beginning and
• increasing later on
• Term 5 Years, bullet
• Interest Mode quarterly, act/360, mod. foll.
• Customer Receives 3M-Euribor
• Customer Pays Euribor Share fixed portion
• Euribor Share 3M-Euribor i.a., max. 4.2000
  p.a.
• initially 100, decreasing by 5.26 points
  per period (finally reaching 0)
• Fixed portion 4.2000 p.a.
• initially 0, increasing by 5.26 points per
  period (finally reaching 100)
• Interest rate determination at the end of a
  period (in arrears)

Alt. Fixed Rate 2.8000 p.a. 3M-Euribor 0.762
p.a. Stand Still in Period 1 0.762
p.a. Stand Still in Period 20 4.2000
p.a. Worst Case 4.2000 p.a. Best Case 0.0000
p.a.
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Smooth-In Swap

• You enter into an interest rate swap which allows
  for the exchange of the 3-month Euribor against
  the payment of the Smooth-in rate for the period
  of 5 years. This interest rate provision is not
  dependent on your funding. The Smooth-in rate
  plus your funding margin will be your total
  interest load of the swap.
• The Smooth-in Interest Rate will be calculated
  from the sum of the fixed rate portion which will
  increase during the strategys maturity and the
  3-month Euribor, multiplied by a simultaneously
  decreasing factor. For the first period the
  smooth-in rate consists of 100 of the 3M
  Euribor, maximum 4.2000 p.a. for the last
  period the smooth-in rate consists 100 of the
  fixed rate of 4.2000 p.a.

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Smooth-In Swap
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Smooth-In Swap
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Smooth-In Swap

• RISKS
• The maximum rate of 4.2000 p.a. is 1.4000 p.a.
  higher than your comparison rate of 2.8000 p.a.
• The participation in low 3-month Euribor rates
  decreases over time.
• REWARDS
• Based on the current 3-month Euribor, you would
  pay an interest rate of 0.7620 p.a. for the
  first period, which corresponds to an interest
  reduction of 2.0380 p.a. in relation to the
  comparison rate.
• You will have the opportunity to participate in
  low 3-month Euribor rates.
• The floating interest portion will reduce during
  the maturity of the strategy. Thus your fixed
  rate portion will become more important and your
  interest load more calculable.
• No premium payment

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Combi-Swap

• Market Expectations Slightly rising or falling
  3M-Euribor
• Term 5 Years, bullet
• Interest Mode quarterly, act/360, mod. foll.
• Customer Receives 3M-Euribor
• Customer Pays 0.5 3M-Euribor 1.9000 p.a.,
• max. 3.8000 p.a.

Alt. Fixed Rate 2.8000 p.a. 3M-Euribor 0.7620
p.a. Stand Still 2.2810 p.a. Worst
Case 3.8000 p.a. Best Case 1.9000 p.a.
3 month Euribor
3 month Euribor
Loan
Combi-Swaprate, max. 3.8000 p.a.
Client
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Combi-Swap

• You enter into an interest rate swap which allows
  for the exchange of the 3-month Euribor against
  the payment of the Combi-Swaprate for the period
  of 5 years. This interest rate provision is not
  dependent on your funding. The Combi-Swaprate
  plus your funding margin will be your total
  interest load of the swap.
• The Combi-Swaprate consists of the 3-month
  Euribor multiplied by the factor of 0.5000 plus a
  fixed rate of 1.9000 p.a. You will pay a maximum
  rate of 3.8000 p.a.

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Combi-Swap

• RISKS
• The maximum rate of 3.8000 p.a. is 1.0000 p.a.
  higher than your comparison rate of 2.8000 p.a.
• Participation in low 3-months Euriborrates only
  with 50 of your interest load.
• REWARDS
• You may participate in low 3-month Euriborrates
  with 50 of your interest load.
• Based on the current 3-month Euribor you would
  pay an interest rate of 2.2810 p.a. for the
  first period, which is an interest reduction of
  0.5190 p.a. in relation to the comparison rate.
• You have hedged a maximum interest rate.
• You do not have to pay a premium for this hedging
  instrument.
• Your best case of 1.9000 p.a. in case the
  3-months Euribor fixes at 0.000 p.a. is 0.9000
  p.a. below your comparison rate.

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Agenda
Initial Situation
Interest Hedging in Times of Uncertainty
Basic Instruments
Participation in Money Market Rates
Appendix
35
CMS-Libor Factor with Cap

• Market Expectations Slightly rising or falling
  2Y-EUR CMS rate. (see appendix)
• Term 5 Years, bullet
• Interest Mode quarterly, act/360, mod. foll.
• Customer Receives 3M-Euribor
• Customer Pays CMS Factor rate 1.20 x 2Y-EUR
  CMS i.a.
• max. 4.00 p.a.
• Interest rate determination at the end of a
  period (in arrears)

Alt. Fixed Rate 2.8000 p.a. 3M-Euribor 0.762
p.a. 2Y-EUR CMS 1.686 p.a. Stand Still
2.0232 p.a. Savings 0.7768 p.a. Worst
Case 4.000 p.a. Best Case 0.000 p.a.
3M-Euribor
3M-Euribor
Loan
CMS Factor rate 1.20 2Y EUR CMS i.a., max.
4.00 p.a.
Client
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CMS-Libor Factor with Cap

• You enter into an interest rate swap which allows
  for the exchange of 3 month Euribor (3M Euribor)
  of your funding against the payment CMS Factor
  rate.
• The 3M-Euribor will be used to carry forward to
  the underlying funding This interest rate
  provision is not dependent on your funding. The
  CMS Factor rate plus your individual funding
  margin will be your total interest load of the
  swap.

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CMS-Libor Factor with Cap

• RISKS
• The factor of 1.2 leads to commensurately higher
  interest load.
• The maximum rate is 1.2000 higher than the
  alternative rate.
• In case of increasing CMS-rates the fixing in
  arrears leads to a higher interest rate load.
• Your minimum interest load is at 0.0000
• REWARDS
• You can participate in low CMS-rates.
• You have secured a maximum rate at no upfront
  premium.
• In case of falling CMS-rates the fixing in
  arrears leads to a lower interest rate load.

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Agenda
Initial Situation
Interest Hedging in Times of Uncertainty
Basic Instruments
Participation in Money Market Rates
Participation in Capital Market Rates
Appendix
39
Appendix
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Frequently Asked Questions

• What does CMS stand for?
• CMS is the abbreviation for Constant Maturity
  Swap. With a CMS Swap, a long-term swap rate
  will be used as the reference rate instead of a
  short-term rate (e.g. EURIBOR).
• How is the fixing of the Capital Market Rate
  determined?
• The fixing is carried out by the independent
  organization ISDA (International Swaps and
  Derivatives Association). Quoted swap rates from
  a panel of various reference banks are used to
  establish an average. The fixing for the EUR swap
  rate is published on the Reuters page ISDAFIX.

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Contact
Maja Crnec Mag. Martina Kranzl ErsteSteiermärk
ische Bank d.d. LPA GmbH Financial Markets and
Investment Banking Zagreb I.Lucica
2 Frankfurt am Main Tel. [phone]
1548 Email mcrnec_at_erstebank.com Email
martina.kranzl_at_erstegroup.com