Hedging Your Bets

Many financial professionals associate internal controls with such matters as separation of duties, reconciliations, and procedures. We do as well, but also believe internal controls encompass the practice of hedging which is a risk reduction technique. It involves the use of a derivative or similar financial instrument to offset future changes in the value of cash flows or an asset or liability. The ideal outcome of a hedge is when the range of outcomes is reduced so that the size of any potential loss is lowered. The three major where we recommend hedging is foreign exchange risks, interest rate risk, and credit risk. This post will focus on the last two as they are more relevant to small businesses.

Interest rate risk is of particular relevance to firms that use large amounts of debt to finance their operations. Absolute changes in interest rate results in changes in interest paid or earned by a company. Reinvestment risk occurs when a company faces a decline in interest at the time to roll over an interest bearing investment. Yield curve risk arises from a change in the relationship between short term and long term interest rates. In turn, this affects a company’s investing and borrowing strategies.

Credit risk is the risk that a borrower will not pay back a loan or the customer will not pay an invoice. For most small businesses, the latter version is more likely.

Interest rate hedging instruments help a firm to side step most of the risk exposure or shift the risk to another party. Banks are very helpful in facilitating these risks.

Forward rate agreements are contracts between two parties to lock in a specific interest rate for a designated period of time (usually a few months). Generally, the buyer is protecting against an increase in interest rates; the seller against a decrease in interest rates. The forward rate agreement is not related to a specific loan or investment. It merely provides protection against interest rate movements. The payout to respective parties is based on a change in interest rates from a reference rate stated in the contract.

Interest rate futures contracts are essentially standardized forward rate contracts traded on an exchange. The standard size for this type of futures contact is $1 million, thus several may be needed to hedge a particular financial instrument. The contracts are priced daily. At settlement, the payouts are made and one party benefits at the expense of the other. If the buyer wants to protect against interest rate variability for a longer period, a year for instance, it is advisable to buy a series of contracts covering consecutive periods.

Interest rate swaps are a customized contract between two parties to trade schedules of cash flows for period of between one and twenty five years. The most common reason to engage in an interest rate swap is to exchange a variable rate payment for a fixed rate payment or vice-versa. Note that only interest obligations are swapped. Accordingly, the company continues to pay interest to the bank under the original lending agreement, while accepting interest payments from a counter party. The company may also receive interest from the party holding its Note receivable while issuing payments to a counter party. The result is that the net amount of interest paid is that amount the company anticipated when it entered the swap agreement, whether it be a fixed or variable interest rate payment.

Many smaller firms forgo these alternatives and simply attempt to match the maturities of their assets and liabilities. For example, financing accounts receivable and inventory with revolving lines of credit; or financing long term assets with multi-year term loans

Credit hedging instruments are used when the company believes it may not be repaid by the party to whom it has lent or sold product. This hedge can be instituted through credit insurance or engaging in credit default swaps.

Under a credit insurance policy, the insurer protects the company against non-payment by its customer. The benefits of credit insurance include the ability to offer higher credit limits to customers, reduced credit staff, and deductibility of the credit insurance premium.

Credit default swaps transfer credit exposure between parties. The seller of the credit default swap agrees to pay the debt of a company (buyer) if the third party borrower defaults on the obligation. Typically a business will pay for a credit default swap to insure against default by a customer on an obligation to the business. A potential issue with these instruments is that the seller of a credit default swap may encounter liquidity problems and may be unable to pay the buyer of the swap if default occurs. Such events transpired during the financial downturn in 2007 – 2009.

In general, financial services businesses are more likely to utilize credit defaults. Service companies, manufacturers, and technology firms are more likely to sue credit insurance.

This post involves internal controls. Many financial professionals associate internal controls with such matters as separation of duties, reconciliations, and procedures. We do as well, but also believe internal controls encompass the practice of hedging which is a risk reduction technique. It involves the use of a derivative or similar financial instrument to offset future changes in the value of cash flows or an asset or liability. The ideal outcome of a hedge is when the range of outcomes is reduced so that the size of any potential loss is lowered. The three major where we recommend hedging is foreign exchange risks, interest rate risk, and credit risk. This post focused on the last two as they are more relevant to small businesses.

Capitol CFO Solutions serves clients in Washington, D.C., Maryland, and Virginia. Please contact us for a free consultation.