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An interest-rate game plan.

As unpredictable as they may be, interest rates can be tamed--if you keep your financial toolbox full and you stick to a clear risk-management plan.

While the dramatic decline in interest rates was a welcome relief to most financial executives, the task of managing rate risk is never complete. Indeed, the next move in interest rates is always uncertain, so you have to develop a game plan not only for your future financing needs but also for your projected interest-rate costs. Yet, financing plans, like rate forecasts, usually change, so your strategy must be dynamic and flexible.

If you fixed your term debt as a way to insulate yourself from rate risk, the plunge in rates over recent years clearly shows you need to manage rate risk in both directions--on the way up and on the way down. In today's competitive business arena, your performance is under continual review, requiring a nimble treasury strategy. But one way you can protect yourself from interest rate risk is to arrange some of your options along a spectrum.

By doing so, you, rather than your banker, can decide the framework of the financing for your firm, given your unique business situation and the interest-rate outlook. The spectrum includes choices other than the traditional fixed- or floating-rate options, depending on how you expect interest rates to move in the future and your loan prepayment inclinations. The chart on page 40 shows how these two key decision variables for term financing structures allow you, as a corporate borrower, to accurately pinpoint the hedging strategy that's right for you.

As you can see, the traditional fixed- and floating-rate options are at opposite ends of the continuum. Clearly, if you're firmly convinced that interest rates will move a particular way during your borrowing period and you have a definite idea of whether you'll prepay your loan, then these two traditional options will meet your needs. However, if you're uncertain about interest-rate movement or the possibility of your prepaying the loan, then one of the other options would better match your needs.

For example, the swap is a widely accepted method of converting floating-rate loans to fixed rates. This alternative offers you protection against rising rates with future flexibility to convert back to other financing options with a less onerous prepayment penalty than the traditional fixed-rate loan.

Another option, called LOWAR, or Lower One-Way Adjustable Rate, acts like a fixed rate if rates move higher, because the starting rate, which is slightly higher than the traditional fixed rate, is the highest rate ever paid. But, if rates fall, the LOWAR rate will adjust lower, similar to a conventional floating rate. Prepayment penalties under this option are moderated as well.

The floating rate with a cap offers the prepayment flexibility of a floating rate but with the protection of a maximum rate, or a cap. This option is really customized rate risk "insurance," which you purchase with an up-front premium determined by the related capped rate, the coverage period and a market volatility factor.


Interest-Rate Sensitivity--The three middle options on the chart come from the evolving market of modern hedging techniques, in which interest-rate swaps and caps are very popular. While swaps and caps both offer the variable-rate borrower protection against the potential costs associated with an increase in short-term rates, the practical implications of the two products are very different. Your decision to use either approach to managing your rate risk depends on your company's rate sensitivity.

If your company has low borrowing levels or can pass rate increases on to its customers, you need less interest-rate protection. But if your company is rate sensitive and it has high debt levels, you need to carefully evaluate TABULAR DATA OMITTED your bottom-line vulnerability to volatile rates. The interest expense may absorb a significant proportion of your total cash flow, and that requires your attention. Choosing to hedge via a rate swap or cap depends primarily on your rate outlook and whether your treasury operation wants to oversee the process.

Interest-Rate Swaps--If you think rates are more likely to rise during your borrowing period, an interest-rate swap to create a "synthetic" fixed rate for your outstanding debt is a good hedging strategy. Although many people think that firms with more sophisticated treasury operations are the ones that use rate swaps, the concept of a swap isn't that complex.

Basically, an interest-rate swap is an exchange between two counterparties of fixed and floating interest flows. There's no exchange of principal. Both flows are calculated using a defined "notional" amount. To enter into a swap, the counterparties execute a separate, stand-alone agreement outside of an underlying loan agreement. This agreement sets forth the terms and conditions of the swap, including the notional amount, term, index on which floating-rate payments will be calculated (for example, three-month LIBOR or prime) and the agreed-upon fixed rate and payment dates.

The fixed rate is usually quoted as a spread over the U.S. Treasury security of maturity equal to the term of the swap. Depending on your firm's hedge objective, you can agree to be either a fixed-rate payor that receives the floating rate or a fixed-rate receiver that pays the floating rate. For example, you could use a swap to convert a fixed-rate loan to a synthetic floating rate or to hedge flows of interest income from an investment portfolio.

When you use a swap to create a synthetic fixed-rate loan, the mechanics of the swap involve an ongoing comparison of the fixed-rate payable and the floating-rate index with net settlements of interest flows usually monthly or quarterly. Once you arrange a swap, the flexibility to "unwind" the agreement, given a change in your rate outlook or business situation, is always possible. But the cost of unwinding a swap is conceptually similar to a mark-to-market calculation for a fixed-income instrument.

Interest-Rate Caps and Floors--Rate caps, on the other hand, provide upside protection, or "fire insurance," for the variable-rate borrower against an unexpected rise in short-term rates. For a premium paid up front, borrowers are protected from a rise in short-term rates above the specified capped rate while benefiting from any subsequent rate declines.

Like swaps, caps are a widely used tool in corporate finance with a broad market of buyers and sellers. Caps are usually sold against the same indices as the floating-rate side of a swap for hedge periods under five years, but cap premiums tend to be prohibitively expensive for longer maturities. Unlike swaps, which involve an ongoing net settlement feature, the rate-cap purchaser incurs a one-time, up-front premium with only potential receipts thereafter. Given this one-way market feature, caps require less treasury administration than rate swaps.

To enter into a cap agreement, the purchaser and seller define the parameters of the desired cap coverage period: the capped index (prime, three-month LIBOR, etc.), the cap level or "strike," the term of the cap with a defined start date, payment dates, a termination date, the notional amount, and the premium to be paid to the seller.

Because cap premiums are a function of the cap coverage period and protected notional amount, the capped rate and a market volatility factor, the pricing of the premium depends on how the purchaser wants the cap structured. In other words, you can back into a rate-cap strategy by first determining the maximum price you're willing to pay for the cap, then adjusting either the capped rate or notional amount or both to match your up-front price objective--voila, customized rate risk insurance. To document the cap agreement, you can use a stand-alone document similar to a swap agreement or write the cap directly into an underlying floating-rate loan agreement.

An interest-rate floor takes the opposite position of a cap, benefiting the purchaser if rates fall below a specified level. You can use floors to either position yourself for an expected rate decline or to offset the cost of a cap (that is, you can buy cap/sell floor). Like caps, market valuation of floors are a function of the index level, time horizon and your expectation of future rate movements.


Here are some examples of how companies are using hedging techniques.

* In 1989, MIDA Dental Plans, a Southfield, Michigan, company with annual sales in excess of $50 million, elected the LOWAR option for a four-year amortizing term loan used to acquire a dental managed care company in Washington, D.C. Since then, based on the pricing structure of this loan, MIDA's LOWAR loan rate has decreased in tandem with the more than five-point decline in the bank's prime rate.

LOWAR users have benefited from falling rates while knowing that, if rates now begin to rise, their upside risk is limited. Why did MIDA choose the LOWAR option? Guy Flannery, vice president of finance, explains, "We're in a business that produces a steady cash flow and we project our operating budgets based on very conservative, worst-case scenarios. We knew the only thing that could hurt us was a rapid unexpected rise in interest rates. We thought of the LOWAR option as an insurance policy against that potential."

In December of 1990, MIDA elected to purchase a prime rate cap against other amortizing installment debt it used to acquire another company in California. Says Flannery, "For a reasonable operating expense, the cap allowed us to protect ourselves for the first two years of the loan rather than the full term. The choices are flexible enough to allow you to protect against any amount for any period of time and cap it at whatever rate you want."

Many floating-rate borrowers began to selectively purchase rate protection against new and existing debt as rates were declining. For these forward-thinking financial executives, the current risk of rising short-term rates is now hedged with favorable cap protection while the companies enjoy the benefit of the lowest rates in over two decades.

* Companies can use multiple strategies simultaneously, using swap and cap agreements at one financial institution to hedge their floating-rate loans at another. For instance, Quanex Corporation, a manufacturer of specialized metal products in steel, aluminum and titanium, headquartered in Houston, Texas, uses a number of banks for its "micro" and "macro" hedging strategies.

Gary Hellner, assistant treasurer at Quanex, says, "To cover a percentage of our bank revolving credit commitment, which was floating at LIBOR, we entered into a cap agreement at 12 percent in December of 1988, when LIBOR interest rates were at 9.5 percent, to limit the maximum exposure while interest rates were increasing."

Hellner chose the cap because the company wanted to limit upside rate risk while still positioning itself to take advantage of expected rate declines. The cap expired in December of 1991, but Quanex is now using other options to control its interest-rate exposure. Explains Hellner, "In July of 1991, our company had committed large amounts of fixed-rate debt, so we put a floor agreement in place for a portion of the outstanding debt. We had $125 million of ten-year unsecured senior notes at 10.77 percent and $34 million of 9.125-percent convertible subordinated debentures. The company opted to place an 8-percent floor on $30 million to protect a portion of the senior notes for three years when LIBOR was at 6.25 percent."

Hellner continues, "This is an in-the-money floor because of a 1.75-percent differential between the floor and LIBOR. Our thought was to place more of our fixed-rate interest into a floating-rate environment, since we anticipated interest rates coming down. As the LIBOR declines, the amount of payments to the company increases."

Quanex has done two of these deals and Hellner is pleased. "Basically, our objective was to find a vehicle that would give us more floating-rate exposure with a derivative product that was in the money. Thus far, these two transactions have returned payments in excess of our original premium, and we still have two years remaining under the floor agreements," he said.

* LDI Corporation, a Cleveland-based, full-service computer leasing and technology integration company with annual sales of $360 million, recently completed a $21-million swap as it sought to convert a portion of its outstanding floating-rate debt to a fixed rate. Explains Steve Kovach, assistant treasurer for LDI, "When we write lease contracts, they're for fixed rates. If we have fixed-rate assets of three- to five-year maturities, it's not wise to finance those assets solely with floating-rate debt. It's prudent to have some portion of it fixed."

At any one time, LDI could be borrowing $130 to $160 million on a floating-rate basis. Says Kovach, "We're not in the business of forecasting interest rates, and there's a limited amount of risk we're willing to accept. Our goal is to match liabilities and assets, and the way for us to get there is to swap out floating rates for fixed rates.

"In the recent declining interest-rate environment, our hedge activity has been limited. You're never going to know when interest rates have hit the bottom, but we thought now was a good time and we're swapping out a larger amount than we have historically. Now that rates have ratcheted down, it's a great time to limit upside risk while at the same time locking in this match funding strategy," Kovach said.


While no one can forecast future market movements with certainty, at least mechanisms are available to manage financial risks. While the list of loan options addresses your rate-risk variable, it's by no means an exhaustive list of derivatives. Moreover, other market risks, such as foreign-exchange risk or commodity-price risk, may affect your business decisions. Certainly, a number of similar techniques are available for hedging these types of financial risks--and a number of service providers, including commercial banks and investment banks, can help you.

Indeed, just as your role as a financial executive in overall corporate performance has increased over time, the product lines of financial service providers have changed to remain competitive. As a result, the pricing of these derivatives is more competitive, too, so you may benefit from shopping around. But don't base your selection of a financial institution to handle this type of transaction on just the cost. Decide if the institution is also willing and able to customize an entire package to meet your needs.

If your financial institution understands your business and if you properly identify your risks and define your objectives, structuring a hedge program to meet your needs can be fairly straightforward. Gary Hellner at Quanex advises, "Look seriously at your requirements and then maintain that focus, as opposed to getting caught up in the variety of derivatives used to accomplish a number of other purposes. It's a very technical area and a novice will have to spend quite a bit of time defining in his or her own mind the differences between what's available, so it's important to keep in mind your ultimate needs. Pay attention to the underlying risk of these transactions."

Mr. Marks is first vice president and Lynn A. Herald is vice president in the funds management department of Comerica Bank in Detroit, Michigan.
COPYRIGHT 1992 Financial Executives International
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Copyright 1992, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Title Annotation:Risk Management
Author:Herald, Lynn A.
Publication:Financial Executive
Date:Nov 1, 1992
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