Have you heard the term "hedging your bets" and wondered what the term “hedging” really means? In the financial world, to “hedge” is to enter into an arrangement to reduce a party’s existing or future exposure to a risk.
You’ll hear the terms “hedge”, “swap” and “derivative” used, sometimes interchangeably: this is a land filled with terminology. A “derivative” is a financial instrument that derives its value from an underlying asset (hence the name). It’s the catch all term for the different types of instruments that can be used to offset risk, speculate or arbitrage between different markets. A “swap” is a type of derivative where two parties agree to exchange cash flow obligations in the future: most usually those relating to interest rates and currencies.
Why hedge in loan transactions?
There are two key risks which are commonly hedged in connection with a loan: interest rate movements and the fluctuating value of one currency against another. It is common practice for lenders to require borrowers to enter into hedging arrangements in respect of some of their exposure to one or both of these risks, and for that requirement to be baked into the loan documents.
A currency swap may be important where the borrower’s business generates revenue in one currency (for example, in Euros), but the loan is denominated in another (perhaps in pounds). Both the borrower and the lenders will want to know that there is some certainty that movements in the exchange rate won’t impact the borrower’s ability to make payments under the loan in the correct currency at the requisite times.
Most companies borrow on a floating interest rate, which is based on a benchmark rate (roughly, the lender’s cost of making that loan) plus a commercially agreed percentage (roughly, the lender’s profit). Benchmark rates can go up (and down), and so a borrower may be concerned about the impact that an increase in the benchmark rate would have on its cost of borrowing. Fixed rate loans are more expensive than floating, so instead interest rate swaps are used. Such swaps either exchange a floating interest rate for a fixed throughout the life of the loan, or provide a “cap” which sets a ceiling interest rate at which the swap kicks in thus enabling the borrower to both be protected from increasing interest rates and take advantage of falling interest rates.
How are hedging arrangements documented?
Market standard documents are used to document interest rate and currency swaps between two parties (known as “over-the-counter” derivatives), using standardised documentation produced by the International Swaps and Derivatives Association (ISDA). An interest rate or currency swap is documented in three parts:
- The Master Agreement: a standardised document containing the ISDA boilerplate provisions which are then amended/ varied by the Schedule.
- The Schedule to the Master Agreement: contains the agreed variations to the Master Agreement.
- The Confirmation: a document containing the economic terms.
All of which are entered into by the borrower with a bank, known as the hedging bank or hedging counterparty.
The requirements for hedging arrangements that form part of a finance transaction will be dictated by the requirements set out in the loan agreement and the other finance documents or occasionally in a hedging strategy side letter. The hedging bank will usually require the same security package as is given to the lender in relation to the loan agreement. The hedging bank either shares the lender’s security package, or the security package is duplicated for the hedging bank, with a priority agreement governing the ranking of the security.
Practical take away
Early on in your transaction consider whether hedging will be required (or is desirable) and if so, who will be providing the hedging. It can be time consuming both to deal with a third-party hedging counterparty and to ensure that the documentation accurately reflects what has been commercially agreed.