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Why hedge interest rate risk ?
When a company borrows to finance its development or long-term projects, the debt may be at a variable rate, indexed to a market benchmark, such as EURIBOR, SOFR, SONIA or another rate, depending on the region. In this case, the financial charges linked to the cost of debt are uncertain and increase if the benchmark rate rises.
To stabilise these financial costs, the company can take out an interest rate hedging contract, which acts as a sort of insurance against a rise in the benchmark interest rate.
How is interest rate risk hedged ?
It is essential to determine the hedging structure best suited to the company's objectives and constraints, as well as to the specifics of the underlying market. A company or project with very stable revenues and costs will not necessarily be hedged in the same way as a project with highly variable revenues or costs. Similarly, depending on the capacity and appetite of the company or project to bear the variability of financial costs, the most appropriate hedging solution will differ.
Several types of financial contract are used to hedge interest rate risk, the most common of which are interest rate swaps, interest rate caps and swaptions, or options on interest rate swaps.
The challenges of hedging interest rate risk
While financing deals are always hard-fought and competitive, derivatives are often are often neglected throughout the financing negotiations.
Sometimes negotiated only a few weeks before closing or even post-closing, and often in conditions of limited competition, derivatives do not always receive the same attention in terms of execution conditions, legal documentation or even structuring. However, poorly defined hedging strategies can expose borrowers to high risks that are not always properly measured.
The price associated with the derivative is added to the cost of financing on a linear basis at the very least, and is even generally accelerated on unwinding, so that controlling the terms and conditions of executing the hedge is at least as important as controlling the financing margin.
Therefore, a few years down the road, the ability to refinance a project and benefit from a lower credit margin may be totally wiped out by the cost of unwinding the derivative, with unwinding costs exceeding the simple change in interest rates. The borrower will then regret not having better negotiated all the financial and legal clauses beforehand.
The ESTER hedging guide
To learn more, ask for a free copy of the ESTER hedging guide below.
