D E R I VA T I O N S

D E M Y S T I F Y I N G R I S K M A N A G E M E N T S O L U T I O N S

VOLUME NO. 24

MANAGING MARKET RISK IS MORE COMPLICATED THAN YOU THINK

THE CHALLENGE

This issue of Derivations comments on the multi-dimensional nature of market management strategies.

When we examine the historical behavior of interest rates, three axes of market movement stand out as something all treasurers should know and understand: the general direction of rates (falling rising) the shape of the yield curve (inverted flat steep) the volatility of rates (implied volatility: low high) Market movements along these axes provide opportunities to improve hedge/trade performance.

Taking Advantage of the Direction of Interest Rates

Corporate hedgers are usually more focused on the direction rates are moving than on the shape of the curve or rate volatility trends. A company concerned about rising rates will execute duration-extending strategies, e.g. issuing fixed rate debt, or swapping existing floating rate debt to fixed. There is nothing subtle here usually the intent is simply to avoid a market move that could cause financial distress.

Directional Rate Management Strategies

Rising Rates Borrowers
Issue new fixed rate debt and pay down floating rate debt Swap existing floating rate debt to fixed rate Buy caps to protect floating rate debt Buy caps as a leg into a collar (Defer adding floor until rate rise takes place) Extend term of existing fixed rate debt using swaps Pay floating/Receive fixed Sell floors as a leg into a collar

Falling Rates

Investors
Sell fixed rate assets, reinvest in floating rate assets Use swaps to shorten duration of fixed rate portfolio Pay floating/Receive fixed

On the other hand, when rates are expected to decline companies seek to reduce debt portfolio duration, usually by raising new floating rate debt to replace maturing fixed rate debt, or by swapping existing debt back to floating rate. There is no strategic subtlety in this case either the intent is just to position the company to benefit if and when rates fall.
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Strategies designed to take advantage of the direction of rates can produce dramatic results. If the CFO's rate forecast turns out to be correct, the savings/gains from aligning the company's rate sensitivity with its rate forecast will be substantial. If rates follow a different trajectory however, the downside can be just as extreme. For this reason many companies set policy limits on pure directional exposure, establishing a range of acceptable rate sensitivity designed to preclude extreme positions. Companies also employ options-based strategies using caps, floors, and swaptions to achieve directional objectives at reasonable risk levels.

Taking Advantage of the Shape of the Yield Curve

The shape of the yield curve plays an important part in framing a forward-looking rate management strategy. Forward interest rates are a function of rates on the cash yield curve. As the shape of the cash yield curve changes, forward rates must adjust to avoid the possibility of creating riskless arbitrage opportunities. Sometimes the resulting forward rates bear little resemblance to economists' forecasts for future rates. When these divergences occur, hedgers and investors take advantage by entering into forward starting financing/hedging arrangements. Steep Yield Curve In May 2002, the steep Canada yield curve implied that future Canadian interest rates would move a lot higher. For example, while the 3-year swap rate was trading at 4.82% on May 22, the 3-year rate a year forward was at 5.66%, almost 90 bp higher. For fixed rate borrowers that disagreed, the high forward rates produced a special opportunity to swap planned future long-term debt issuance back to floating rate at tighter spreads than would likely be available at the time of actual issuance. Investors with the same view used forward starting swaps to lock in attractive yields on future long-term investments.

Canada 3-Year Swap Forward Curve

May 22, 2002

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U.S. Swap Curve

December 15, 2000

Inverted Yield Curve When the yield curve inverts, a different set of opportunities arise. For example, the U.S. swap curve on December 15, 2000 was inverted to.53% between 3 months and 2 years. Inversions almost invariably signal economic weakness and impending central bank easing, which is a strong positive for fixed income investors. Investors who believe the curve will correct by short rates falling faster than long-term rates use relative-value strategies to take advantage. They add to short-term investments in maturities where the largest decline in rates is expected, offsetting risk by reducing exposure in maturities expected to change the least. The effect of the inversion on forward rates is to push them sharply lower. This creates an opportunity for borrowers who are more bullish on economic recovery (accompanied by higher interest rates) than the yield curve has priced in. These borrowers use forward rate agreements and forward starting swaps to lock in low rates today for future fixed rate debt issuance.

Managing Market Volatility

Because the value of options is directly affected by changes in market volatility, options strategies are widely used for trading and hedging volatility. Proprietary traders structure trades to profit from movements in volatility, regardless of the direction underlying prices/rates are moving. Mortgage investors and servicers have one-sided exposure to interest rate volatility they stand to lose if rates drop more rapidly than expected. Investors' exposure is to prepayment risk, which increases as rates drop. Servicers are exposed to both prepayment risk and to pipeline fallout risk. Both use options (usually interest rate floors or options to receive a fixed rate on a swap) to hedge away volatility risk.

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Non-financial companies need to be aware of market volatility trends as well because volatility influences the relative cost and performance of hedges. For example, when volatility is low, companies prefer to hedge floating rate risk using lower-cost interest rate caps rather than using interest rate swaps. Low volatility is also a plus for fixed rate debt issuers bringing callable debt to market. Lower volatility reduces the cost of the embedded call option, and translates into a lower coupon on the debt. When volatility is higher than usual, options become more valuable. Companies take advantage by issuing debt with embedded short options (e.g. puttable notes), or executing "covered write" strategies, such as selling puts on the company's common stock to lower the cost of stock compensation programs. A similar strategy can be employed in the debt portion of the balance sheet writing bond puts or options to receive a fixed rate in a swap as a proxy for debt the company intends to issue in the future can substantially lower the cost of debt when option volatility is high. S U M M A RY

Effective rate management strategies are more than one-dimensional. Not only do CFOs need to attend to the direction that rates are moving, they also must be aware of the opportunities and risks thrown up by the changing shape of the yield curve, and by fluctuations in the expected volatility of interest rates.

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