During a financing or refinancing project, the interest rate or exchange rate hedging derivative is often the poor relation of the operation, despite its crucial importance.

While financing is always the subject of fierce negotiation and a competitive process is the norm, the derivative is often neglected during financing transactions.

The derivative, which is sometimes negotiated post-closing and often under conditions of limited competition, does not always receive as much attention in terms of execution conditions, legal documentation, or even structuring. Yet if poorly defined, the hedging strategy can subject the borrower to high risks, which are not always properly measured.

Given that the cost associated with the derivative is added on a very linear basis to the cost of financing, sorting out the conditions for executing the hedge is as important as sorting out the financing margin.

This is especially the case since, a few years down the line, the ability to refinance a project and benefit from a reduction in credit margin may be completely wiped out by the cost of unwinding the derivative, with unwinding costs sometimes exceeding the simple variation in interest rates. At this point the borrower will regret not having negotiated all of the financial and legal conditions properly at the outset.

Hidden complexity

Interest rate derivatives, especially when they are simple, have become fairly standardised products over the years with good transparency on prices and standardised operating conditions. This is especially the case because:

- They are treated in a collateralised framework: in other words, the derivative’s market value gives rise to a very frequently readjusted cash exchange – collateral.

- They are documented in a standardised framework contract that defines in detail how the derivative will work over the course of its lifetime.

However, when associated with financing, derivatives become much less standardised products due to:

- The interaction between the loan and the derivative.

- The almost complete absence of collateralisation of the derivative’s market value.

- The derivative’s documentation, which may deviate significantly from market standards.

Generally speaking, a derivative associated with financing needs to be given special attention.

The specific characteristics of derivatives backed by financing

a. Less competition

A derivative associated with financing can quickly turn into a captive derivative. Less competition often means increased costs, so it is important to be vigilant:

- Try to organise execution in a way that preserves competition.

- If this is not possible, set up effective safeguards against potential drift in execution costs.

b. Less price transparency

When a derivative associated with financing is not collateralised, the cost of executing the derivative is significant and not very transparent. This cost often consists of at least two distinct elements:

- An execution margin, which is supposed to represent the bank’s cost for hedging the operation on the market.

- A so-called credit margin, the purpose of which is to compensate the banking counterparty for the credit risk associated with the operation. Like the margin taken on financing, this margin covers the provision for credit risk that the bank will have to record in its accounts following the operation, but also the capital cost of the operation (and therefore the remuneration for the bank for mobilising its capital).

But although market practice tends to ensure that the sum of these two elements systematically represents between 10 and 20 basis points per year, the breakdown of the cost by each bank, and its justification, is lacking in transparency. However, there are techniques that can be used to compare the credit margin and the derivative margin and therefore to improve the borrower’s ability to negotiate about the derivative.

Finally, unlike financing in which it is always the bank which incurs a counterparty risk with respect to the borrower, the credit exposure on the derivative is symmetrical: in many cases it is the borrower who may incur a risk with respect to the bank. This risk is never valued and is often poorly controlled in the derivative documentation.

The interaction between the loan and the derivative increases the complexity

a. The question of the floor on the loan

When financing is at a variable rate, a relatively recent but widespread market practice consists of setting a minimum rate for Euribor (the ‘floor’), which is often zero, but sometimes 0.25% or 0.50%.

The whole matter of this floor rate is not very clear. In the current context of negative rates, it is not certain whether it is legal for loans to carry a negative rate. But flooring the loan rate at zero would lead to flooring Euribor at ‘minus the margin’ and not at zero.

In any case, whether the floor for the loan is at Euribor or at Euribor minus the margin, there must be an identical floor in the swap in order for the hedging to be perfect. Otherwise, as soon as Euribor moves below the floor level, the fixed rate paid by the borrower is increased by all the variation in Euribor below the floor.

For example, if a borrower has fixed a rate of 2% on a swap, the variable rate is floored at zero in the loan and not floored in the swap, and Euribor is -0.32%, the final rate paid by the borrower after the swap becomes 2.32%, since the variable leg of the swap pays a coupon (-0.32%) which is no longer matched to the financing rate (0%).

The hedging then ceases to provide protection, which may breach the covenants as the contractual requirement to hedge the risk documented in the loan is no longer met: the rate becomes variable again depending on variations in Euribor. It is now a fall rather than a rise in rates that increases the cost of financing, but either way the cost of borrowing is variable. For certain listed groups, this non-compliance with covenants may even lead to the acceleration of the debt with all the associated consequences.

With the persistence of rates several tens of basis points below zero, this issue of the floor should be given careful consideration by borrowers, not only for new operations but also for existing operations that are poorly backed. There is also a question to be asked about the role of the bank, which required a rate hedge to manage its counterparty risk but structured a hedge that allows risk to persist in situations where rates are falling.

b. The question of calculating early repayment charges

Early repayment of a loan generally triggers the termination of the derivative. However, the methods for calculating the repayment charges on the loan and on the derivative are generally very different:

- On the variable rate loan, the repayment involves the total or partial cessation (1) of payment of the credit margin.

- On the derivative, early termination automatically accelerates the payment of the credit margin. The documentation almost never gives the borrower the right to recover all or part of the credit margin between the termination date and the initial maturity date of the derivative.

As a result, when the fixed rate of the swap incorporates a credit margin, the derivative’s market value automatically includes the entire current value of this margin from day one onwards – and it is precisely this market value which is taken as a reference point for the value of the termination charge.

Yet when the derivative is unwound, the bank’s credit risk immediately vanishes, so it makes no sense for the residual value of the loan not to be returned to the borrower at this point. For this to be possible, it needs to be specified in advance with the banking partners and included it in the documentation.

Here again, the borrower will benefit from clear contractual clauses which reduce uncertainty and maximise the chances of being able to refinance the loan one day.

The case of the internalised derivative

The credit documentation may use the concept of ‘internalised derivative’ where the borrower borrows directly at a fixed rate even though the loan contract refers to a variable rate loan and a hedging derivative.

In this case, the lender sometimes imposes an additional margin which is deemed to cover the marginal credit risk linked to the internalised derivative, even though the derivative is fictitious: it only exists because the loan is at a fixed rate rather than a variable one.

However, there are two good reasons why, when the loan is at a fixed rate, the credit margin should be lower than for a variable rate loan with a hedging derivative:

- A fixed rate loan is by definition fully hedged through the rate and does not subject the borrower to any variability in financial costs. The borrower’s probability of default should therefore be lower than in the case of a variable rate loan or a variable rate loan partially hedged by an interest rate derivative.

- If a variable rate borrower who has contracted a hedging derivative defaults, the claim on the derivative is subject to asymmetric treatment: if the derivative’s market value is in the bank’s favour, the bank will put in a claim when the borrower is declared bankrupt, but if the market value is in the borrower’s favour, the bank will have to pay this value in full to the liquidator. Conversely, the internalised swap benefits from symmetrical treatment: it can either reduce or increase the bank’s claim on a defaulting borrower.

This symmetry of the internalised derivative considerably lessens the bank’s risk.

If, despite all this, there is a credit margin on an internalised swap, the issue of the swap termination balance must be properly documented so that in the event of early termination the borrower is not required to pay a charge that also includes the present value of this margin.

Improving analysis and negotiating capacity

Before setting up financing or hedging, or when refinancing, it is essential to:

- Analyse the most effective derivatives to put in place, given the objectives and constraints: product, contractual arrangements, timing of hedging, whether pre-hedging is possible and in what form.

- Simulate the derivative’s financial conditions in advance in order to calibrate the target debt as accurately as possible.

- Negotiate margins with the bank or banks, ensuring transparency in particular on the relative level of the margin on the loan and the margin on the associated derivative.

- Scrutinise the clauses on the derivative in the documentation.

- Maintain competitive pressure and transparency on derivative prices.

- Prepare for the execution of the derivatives (dry runs).

- Optimise the financial conditions obtained during the derivative’s final execution.

- Check confirmations and contracts.

ESTER has been developing its Hedge Advisory service with financial institutions, businesses, project financing companies and funds (or their investors). ESTER has consistently demonstrated its ability to establish a constructive dialogue – backed up by expertise – with its clients, and to obtain concrete results for them.

1 - If the early repayment penalty allows, for example, the use of the fund redeployment cost to estimate the bank’s opportunity loss associated with this early repayment and to quantify the charge.