Metro DO Porto: Snowball case

The contract between BCP and MdP involved a simple swap contract with an agreement for semi-annual fixed rate coupon at the rate of 4.76 percent. The aim of the contract appears to be very clear, that of ensuring that MdP hedging is in place against a rise in the interest rate over the fixed rate. It is not clear, after the contract renegotiation, what the contract was hedging against. The aim was to reduce a 4.76 percent fixed rate semi-annually to a clear 20-year period fixed-for-floating swap. The goal of covering a 20 year floating loan was a good hedging strategy when he interest-rate risk is considered .The terms of the contract would have one to assume that MdP would be hedging against interest rate fluctuations, as long as the fluctuations did not go beyond the set barriers of 2 percent and 6 percent. The bank had considered various proposals from a number of banks but resolved to enter into contract with BST. In return, the MdP agreed on payment of 1.76 percent to the bank and a quarterly coupon floating rate, with a spread calculation tied to 3-month Euribor.  This simply means that after a period of two years, for each quarter that the 3-month Euribor would fall outside the 2percent- 6 percent interval, this clause would take effect, considering the past spread. The calculation on spread would decrease by 0.5 percent for every time the 3-month Euribor was in 2-6 percent interval but to decreasing below zero.

For the purpose of risk management, one has to consider whether this strategy as represented in the contract would adequately serve the hedging purpose.  Originally, the loan had a floating rate, which means that it was exposed to a rise in the interest rate, a risk that a good strategy has to hedge against. At the time of the interest rate swap, the Euribor rate was within the range of 2 percent – 6 percent, but the agreement did not hedge against a decrease in interest rates. In addition, any loan with a floating interest rate is obviously hedged against a reduction in interest rates, but the above contract limits this, where hedging is done until reference rate is 2 percent. Any movement outside the range, the due periodical payments that are variable can have an exponential growth, without a reset clause. This makes the adequacy of the contract questionable in regard to simple hedging. Such kinds of questions can render this a case of risk management strategy but which was badly timed. If it were for speculation purpose, a hedging aim would be the least for the railway company. Given the nature of the interest rate fluctuation in the market is unpredictable; the speculation purpose on the side of the firm would be quite illogical. A swap of floating rate for fixed rate was, therefore, used for the purpose of protecting the company against any increase in cost of the loan as a result of an increase in the interest loans in the market. The fact that the MdP denied the contract as aiming at effective risk management does not qualify this to be a speculative venture. It was a risk management strategy, only that the interest rates fell below the level that was anticipated in the market.

Net cash flow

Excel workbook

Contracts for interest rates swaps can be of benefits to company’s executives and even for bankers. In the case of companies, executives may enter into such contracts with aim of risk management. If the company borrows on interest rates that are variable -floating – they are usually exposed to the risk of fluctuating interest rates in the future. In order for the executives to mitigate this risk, they enter into an interest rate swap agreement. In the contract, the company will pay fixed rates of interest on the basis of a notional principle to the banker while receiving cash flows on variable interest from the bank (Gottesman, 2016). This provides protection for the firm against the changing rates of interest. If the variable interest decreases, the amount of company’s outflow of interest of cash on borrowing will be lower together with receipts from the banker. An increase in the variable interest will see the offset of the increased cost of borrowing by the increased receipts from the bank. Unlike other tools of managing the risk of interest rates such as interest options and futures derivatives, the swap of interest rates gives a customization advantage (Buetow & Fabozzi, 2000).  Unlike the aforementioned derivatives, termination of swap may not be a difficult and costly process. The management considers such swaps as true hedges for the sake of risk management. The innate motivation for using the swaps is to reduce the earnings variability and therefore, protect the company from any distress and also to reduce taxes (Buetow & Fabozzi, 2000). The management may also enter into such contracts with an aim hedging in order to match cash flows and lower the explosive nature of executive compensation. Another motivation for using the swaps includes speculation purpose. A transient use of the swaps by the executives may indicate a speculative aim rather than a hedging motive (Buetow & Fabozzi, 2000).

Given that firms can access the loan through a fixed interest rates in the first place, there is no rationale for creating a scenario where hedging will be required. Borrowing on such an interest rate can eliminate any risk of fluctuating rates of interests, meaning there is no risk of hedging. The executives using just one type of loan and using a swap of interest rates justify the contract on the basis of lack of access and / or the existence of a comparative disadvantage in this type of loan (Gottesman, 2016). If such a reason does not exist, the executives may not have a reasonable ground for entering into a contract that will see changes in interest rates that increases financial risk to the company. Another reason offered involves an argument on comparative cost which holds that the floating rate may offer comparative advantage to the borrower even though fixed rate is better. The executive will look for a party with a fixed rate comparative advantage and get into a swap contract to have an exchange of the respective cash flows. In this case, the executives are more motivated by the need to reduce cost than reduction of risk (Buetow & Fabozzi, 2000).  Like in the case of MdP, the motives of the company seem to have entered into the contract aiming at reducing the cost associated with interest rates fluctuations.

Banks on the other hand may aim at benefiting from such a contract especially in the case of raising interest rates. If the interest rates rise, deposit runoff, a margin pressure and more defaults on loan from the floating rate borrowers who are struggling becomes a valid concern. More so for the medium-sized lenders and borrowers who are actively involved in the swap market, they stand to gain much from an increase in interest rates (Gottesman, 2016). The idea of a swap contract can also be utilized by banks as a hedge in the time of a rising interest rate environment. The banks will enter into swap agreements with borrowers so as to facilitate a solution for long-term hedging. If the borrower is a going concern who is actually servicing the loan, it obtains higher costs of interests through a rebate (Gottesman, 2016). The bank may also enter into such a swap contract with a dealer who is bigger money-center bank. In case the borrower default in payment when interest rates are high, it would be possible to unwind both swaps. The later swap agreement can be result to gains upon termination which would improve the position of the bank in finding a solution for the troubled commercial loan. The upstream dealer has unquestionable ability to handle its obligations (Buetow & Fabozzi, 2000). It should be considered that the initial purpose of having the interest swaps is to offer tangible payoff when most needed, that is to say when the rates of interests are high.

The use of derivatives may come with various mishaps, due to latent challenges especially in the over- the-counter derivatives market.  Given the many shortcomings associated with how the market functions, derivatives have been viewed as financial weapons of mass destruction (Vahey, 2014).Of the major danger associated with derivatives includes the risk that a party in these derivatives may be unable to fulfill its end of obligations and also lack of margin collateral put in place to cover any possible losses (Gottesman, 2016). The risk is especially high if there is a web of swap agreements that have been created and involving many parties with banks taking a central role. In order to handle such risks reduce the dangers that may arise, a restructuring of the derivatives market may be necessary with a purpose of addressing any excess credit risk relationships. This restructuring would involve some standardized swaps being submitted a central counter party and cleared through it (Gottesman, 2016). This party would stand between two parties that have entered into an agreement and provide a guarantee that there will be the performance of the financial obligations. Unless the derivatives agreements are guaranteed through collateralization, their value will ultimately depend on the credit worthiness of the parties involved.    

Where derivative are used for the purpose of risk management, there should be created a hedging policy that will ensure effectiveness in hedging.  This will ensure that derivatives are leveraged in a disciplined way so that risk is reduced while making sure that managers do not fall into the temptation of speculating on the direction of rates, prices and the markets (Gottesman, 2016). The motivation for transactions should be the management of asset and liability but not the speculation of the future. To avoid any mishap with the derivatives, a comprehensive policy on hedging should be implemented where there is a definition of the risks that a firm will hedge against, quantities and kinds of instruments that should be bought and specifications on the costs to be incurred in the process. In addition, the person to be responsible for the derivatives should be identified, so that they oversee the implementation of the policy in the transactions and following up on the performance of the financial obligations more so for the borrowers (Gottesman, 2016).  Moreover, well structured programs especially on hedging should be developed to reduce the chances of mishaps occurring.  For instance, a hedging program would utilize a combination of agreement on fixed-price and call options. Call options provide the firm the right to undertake certain exchange agreements in future but not the obligation (Kroll, 2005).

References

Gottesman, A. A. (2016). Derivatives essentials: An introduction to forwards, futures, options, and swaps.242-245

Buetow, G. W., & Fabozzi, F. J. (2000). Valuation of interest rate swaps & swaptions. New York: John Wiley and Sons Ltd.7-11