Hedging borrowing costs is a strategy that aims to reduce the risk of fluctuations in interest rates affecting the cost of debt. It involves using derivatives, such as interest rate swaps, treasury locks, or forward rate agreements, to lock in a fixed or favorable interest rate for a future borrowing.
For example, suppose a company plans to issue a 10-year bond in six months and is concerned that interest rates may rise by then. The company can enter into a 10-year interest rate swap, in which it agrees to pay a fixed rate and receive a floating rate based on a benchmark, such as LIBOR. By doing so, the company effectively hedges its borrowing cost at the fixed rate of the swap, regardless of the market interest rate at the time of issuance. If interest rates rise, the company will benefit from the swap, as it will receive higher payments from the floating rate and pay lower interest on the bond. If interest rates fall, the company will lose from the swap, as it will pay higher payments on the fixed rate and receive lower interest on the bond. However, the net effect of the hedge will be that the company’s borrowing cost will be close to the fixed rate of the swap.
Hedging borrowing costs can help a company manage its cash flows, budget, and financial planning more effectively. It can also reduce the exposure to interest rate risk and volatility, which can affect the company’s profitability and credit rating. However, hedging borrowing costs also involves some costs and challenges, such as transaction costs, counterparty risk, hedge accounting, and hedge effectiveness12. Therefore, a company should carefully evaluate its hedging objectives, policies, and strategies before entering into any derivatives contracts.
Basic Theory
The basic theory behind hedging borrowing costs is to protect a company from adverse interest rate movements. When a company borrows money, it is exposed to the risk of interest rates rising, which would increase borrowing costs. To hedge against this risk, the company can use interest rate derivatives, such as interest rate swaps or futures contracts.
Procedures
- Identify Borrowing Exposure: Determine the amount of the loan, the interest rate, and the term of the loan. This information is crucial for assessing the potential impact of interest rate movements on borrowing costs.
- Choose a Hedging Instrument: Select an appropriate financial instrument for hedging. Common choices include interest rate swaps, where the company exchanges its variable-rate interest payments for fixed-rate payments.
- Calculate Hedge Ratio: Determine the hedge ratio, which represents the proportion of the loan amount to be hedged. This is essential for aligning the hedging instrument with the exposure.
- Implement Hedge in Excel: Utilize Excel to model and implement the hedge. Input the relevant data into a spreadsheet, calculate the cash flows under different interest rate scenarios, and assess the effectiveness of the hedge.
Scenario: Hedging Borrowing Costs
Let’s consider a scenario where Company XYZ borrows $1 million at a variable interest rate linked to the LIBOR. The company decides to hedge against potential interest rate increases by entering into a 2-year interest rate swap with a fixed rate of 4%.
Excel Calculation:
- Loan Details:
- Principal Amount: $1,000,000
- Initial Variable Interest Rate: 3% (LIBOR + 3%)
- Interest Rate Swap:
- Fixed Interest Rate: 4%
- Hedge Ratio: 50% (half of the loan amount is hedged)
- Excel Formula for Fixed Payment (Hedged):
=PV(4%, 2, -500000) - Scenario Analysis: Assume LIBOR increases to 5% after one year.
- Excel Formula for Variable Payment (Unhedged):
=PV(5%, 1, -1000000) - Excel Formula for Total Payment (Hedged):
=FixedPayment + VariablePayment - Excel Formula for Total Payment (Unhedged):
=VariablePayment
Results:
- Total Payment with Hedging (after one year): $530,860.80
- Total Payment without Hedging (after one year): $553,097.35
Other Approaches
- Interest Rate Caps: Purchase interest rate caps to limit the maximum interest rate payable on the variable-rate loan.
- Forward Rate Agreements (FRAs): Enter into FRAs to lock in future interest rates.
- Combination Strategies: Combine multiple hedging instruments to create a comprehensive risk management strategy.
