Incorporating Expectations into Hedging Decisions

The problem with expectations is that you can’t count on them.

Although the financial landscape is ever-evolving, this year’s inversion of the yield curve on Treasuries marked a significant shift in expectations. Under a normal yield curve, where longer-maturity interest rates are higher than shorter-maturity rates, consensus expectations generally call for rising short-term interest rates. But the recent inversion flipped those expectations. For as long as the inverted yield curve persists, the consensus forecast will point to falling short-term interest rates. This change has a critical impact on the economics of hedging.

For most commercial enterprises that bear interest rate risk, the preferred tool for managing that risk is the interest rate swap, which allows counterparties to transform any variable-rate interest rate exposure to a synthetic fixed interest rate, or vice versa. Companies outside the financial services industry commonly face interest rate exposures as a result of variable-rate borrowing, and they frequently hedge these exposures using interest rate swaps to lock in a known, fixed interest rate.

At any point in time, the fixed rate that the market offers on an interest rate swap will reflect the prevailing market consensus for the projected path of the underlying variable interest rates throughout the term of the swap—projections that are readily discernable from Eurodollar futures prices. Eurodollar futures, traded at the CME Group, are among the most actively traded of all futures contracts. They effectively provide market-consensus forecasts for three-month LIBORs commencing the third Wednesday of each expiration month. For instance, if the June 2020 Eurodollar futures contract were trading at a price of, say, 98.615, it would indicate that the market expects three-month LIBOR to be 1.385 percent (100.000 – 98.615 = 1.385) for the three months starting the third Wednesday of June 2020.

Although LIBOR is likely to become obsolete by the end of 2021, the CME Group lists contract expirations extending out for 10 years. With minor manipulations, a treasury analyst can generate an effective term rate—or at least a close approximation—by assessing the prices of a “strip” of successive Eurodollar contracts covering the term of the exposure under consideration. Moving from such a strip of futures to the expected rate that a swap dealer would quote largely comes down to adjusting the strip’s yield to reflect the credit quality of the counterparties involved in the swap.

With a normal yield curve, interest rates derived from futures prices are generally increasing for successive expirations months. In contrast, with an inverted yield curve, these futures rates are generally declining. That means you can expect term fixed rates on swaps to be above current variable interest rates with normal yield curves, but below current variable interest rates when the yield curve is inverted. The inverted yield curve thus creates an especially attractive opportunity for variable-rate borrowers. It gives them a chance to lock in an interest rate that offers an immediate discount to the rate that they would be paying if the exposure were left unhedged.

Do these conditions mean that the firm’s bottom line will be better if it hedges than if the company chooses not to hedge? Not necessarily. The answer to that question depends on how variable rates ultimately differ from the implied forecasts underlying swap pricing when swaps are originally traded.

Decision-makers should recognize that if consensus expectations are, in fact, realized—i.e., short-term interest rates adjust to the exact rates implied by the futures market when the swap is initiated—hedging will have no bearing on the company’s financial performance. Put another way, if the consensus forecasts are realized, earnings outcomes will be essentially the same, whether a firm hedges with swaps or not.

Of course, this outcome is highly unlikely. Inevitably, variable interest rates will differ from those predicted by any initial consensus forecast. If short-term interest rates move to levels above the initially forecasted rates, the unhedged enterprise will bear a higher effective interest rate than the hedged enterprise. But if short-term rates converge to lower rates than the implied forecasts, the unhedged enterprise will realize a lower effective interest rate than the hedged enterprise.

The decision to hedge a variable interest rate exposure shouldn’t reflect decision-makers’ speculation on whether variable interest rates will overshoot or undershoot the forecasts implied by futures pricing. Instead, prospective hedgers should assess the term rate that they could realize by hedging with a swap. Then it’s simply a judgment call: Either accept this rate and lock it in, or don’t hedge and continue to bear the market exposure.

Currently, the inverted yield curve affords variable-rate borrowers the capacity to lock in a rate below the current variable-rate level—a situation that would seem to be akin to being paid to lock in an interest rate. This situation will evaporate as soon as expectations change and the yield curve again becomes upward-sloping.

Timing a Hedging Transaction

A further consideration underlying the hedging decision is timing. If treasury managers at Company X are considering entering into a swap to lock in an interest rate for some variable interest rate exposure, should they do the hedging transaction now, or should they wait? Perhaps, by waiting, they might be able to secure a more favorable (i.e., lower) fixed rate on the swap, but perhaps not.  By hedging today, Company X might forgo the opportunity of locking in a better rate should market conditions improve.  At the same time, locking in right now could avoid the prospect of swap rates moving to less attractive levels.

Faced with this dilemma, a treasury team may consider phasing in hedges over time. Nothing says that hedges should be an all-or-nothing proposition. Rather, the idea of risk mitigation should be thought of as a process, whereby hedge coverage is adjusted over time. Depending on the conditions, hedge coverage could vary anywhere between the extremes of zero percent to 100 percent of the exposure.

Ultimately, where firms place themselves on this spectrum should reflect a forward-looking assessment of the probability of forthcoming adverse interest rate moves and the firm’s risk tolerance. Of course, neither is static. Thus, it is best practice to reassess these considerations periodically. It also makes sense to re-evaluate hedge coverage anytime notable market adjustments occur.

How frequently is “periodically”? Different firms have different perspectives, but these parameters should frame the decision: Too-frequent adjustments could lead to whipsaw trading in derivatives, where cumulative derivative results might turn out to be unrelated to the longer-run interest rate adjustments that actually occur. On the other hand, too-infrequent adjustments mean that the degree of hedge protection in place may be suboptimal for too much time.

See also:

• Assessing the Impact of the Fed’s Interest Rate End Game
• Taking Advantage of the Low Interest Rate Environment
• Interest Rate Response for Small and Midsize Companies
• Options: A Good Option for Currency Hedging
• Cash Flow Hedging Best Practices

My own sense is that, barring any clear and obvious change in macroeconomic conditions affecting interest rates, adjustments made more frequently than, say, once a month might be too much—and adjustments occurring less frequently than quarterly might be too few. Ideally, the length of the period should be long enough to ensure that changes would be made in response to real market changes, as opposed to noise.

What About Now?

In the current environment, short-term interest rates happen to be at historical lows. And while the consensus view appears to be calling for rates to fall even further, the bottom isn’t likely to be all that much lower than today’s rates. On the other hand, when rates do begin to rise again, those increases could end up being quite large, just to get us back to historical norms.

No one knows exactly what rates are going to do in the future. Nevertheless, I feel that the inverted yield curve offers an especially attractive time to be layering in hedges against rising interest rates. Market expectations that interest rates will retreat further have made swaps quite affordable.

If rates do move lower than today’s consensus forecast, a hedge placed today will necessarily forgo some portion of that rate decline. But if turns out that we’re at or near a rate bottom and expectations reverse, I would expect the cost of not hedging to be much more severe than the limited downside risk of missing out on rates going even lower than forecasted. Deciding to hedge after that sea change occurred would present a much less attractive rate fixing opportunity. A bird in the hand…

Ira Kawaller is the principal and founder of Derivatives Litigation Services, LLC. Kawaller holds a Ph.D. in economics from Purdue University and has held adjunct professorships at Columbia University and Polytechnic University. He writes and lectures prolifically, largely focusing on derivative contract market activity. You can reach him at igkawaller@gmail.com.