Market Update August 2009

Hedging in a Credit Constrained World

While the current market and financial environment has resulted in numerous challenges for companies, the resulting relatively low interest rates have created opportunities for new or additional hedging and/or restructuring of existing hedges.

However, problems frequently arise when a company approaches its bank(s) for the additional credit exposure that incremental hedging may involve. Given the banks’ desire for higher risk-adjusted returns, most banks have a limited credit appetite for derivatives-based credit exposure arising from interest rate, currency or commodity hedging. This constraint is further exacerbated by the large mark-to-market exposures banks are carrying on their clients’ pay-fixed interest rate swaps, particularly with their leveraged customers.

As a result, we’ve seen a number of banks either refuse any incremental credit exposure or significantly increase their implied credit margins. The graph below illustrates that bank credit spreads have not declined commensurate with Junk Bond credit spreads. PMC has worked with numerous clients on hedging structures that entail little or minimal incremental credit exposure:

While bond-based credit spreads have narrowed, bank credit spreads have not.

Caps: Provide unlimited protection above a stated strike level. The decline in implied forward market volatility has resulted in lower up-front or deferred premiums.

Corridors: Reduce the cap premium by limiting protection above the cap strike (not to be confused with a Collar).

Step-Up Strikes and/or Amortizing Notionals: Also reduces the up-front premium by more closely aligning the protection parameters with the client’s specific needs.

Options: Particularly applicable in currency and commodity hedging applications, these can be structured to mitigate the up-front or deferred premium.

Deferred Premium Options: Premium is paid over time.

Collateral or Margin Accounts: Enables clients to use an interest-bearing account as collateral for credit generating hedges. The amount of collateral is determined by and regularly adjusted to the mark-to-market value of the underlying transaction.

PMC Treasury is an independent corporate treasury advisory firm with clients throughout Europe, the US and Asia-Pacific. Started in 1989, PMC consultants advise clients on operational treasury matters such as treasury functions, best practices & controls as well as interest rate, currency & commodity hedging.

Back