How to Improve Your Fixed–Floating Mix and Duration
STEP 4: TACTICAL CONSIDERATIONS
4. Repeat: when the swaps mature, repeat the algorithm in stages 2 and 3 until the present date
Obviously, this solution is impossible to implement in practice since no one can predict the future Euribor or swap rates. However, we can use this theoretical concept to illustrate the value of perfect timing. The results of the algorithm, showing the perfect hindsight solution are shown in Figure 7.16 and Table 7.11.
Figure 7.16 Perfect hindsight solution
0
The average fixed proportion is 82%, and the average duration is 2.5 years. Even though the perfect hindsight solution is not possible to implement in practice, it is shown to illustrate the power of good timing, ie, fixing at low rates for JSCOM in Figure 7.17.
Figure 7.17 Interest cost premium over floating 2.5
HOW TO IMPROVE YOUR FIXED–FLOATING MIX AND DURATION
Table 7.11 Perfect hindsight solution
Perfect hindsight solution
Date Fixing tenor (y) Rate (%) Savings (%)
03/01/1989 5 6.22 2.09
03/01/1994 2 4.89 0.17
01/02/1996 1 3.25 0.03
09/07/1997 1 3.30 0.18
27/04/1999 3 3.00 0.92
13/06/2003 2 1.99 0.14
05/09/2005 3 2.38 1.30
Remaining Floating 0.00
Average saving 0.86
Premiums at the time (%)
Date 1y 2y 3y 4y 5y 6y 7y 8y
03/01/1989 −0.98−1.63−2.09−2.34−2.09−1.50−0.94−0.34 03/01/1994 −0.18−0.17 0.38 0.84 1.07 1.46 1.62 1.73 01/02/1996 −0.03 0.40 0.85 1.46 1.67 1.85 2.16 2.52 09/07/1997 −0.18 0.26 0.66 0.67 1.00 1.41 1.87 2.22 27/04/1999 −0.35−1.03−0.92−0.53−0.03 0.39 0.71 0.86 13/06/2003 −0.20−0.14 0.02−0.04−0.21−0.12 0.00 0.00 05/09/2005 −0.39−0.89−1.30−0.97 0.00 0.00 0.00 0.00 Remaining −0.98−1.63−2.09−2.34−2.09−1.50−0.94−0.34 Average saving−0.18−0.17 0.38 0.84 1.07 1.46 1.62 1.73
When is it good to fix rates?
In the past, strong minimums were good fixing times for shorter maturities: this is quite intuitive, since the average Euribor is quite slow to change, while the swap rates are more volatile. Therefore, when the swap rates are low, it should be a good time to hedge. This can be seen in Figure 7.18 (see also Table 7.12).
We now try to see the effect of higher duration on the savings at the strong minimums. As expected, for longer duration the savings are substantially reduced, even at very strong minimums. This too is quite intuitive, since for long durations the average swap premium increases considerably, and therefore only extremely low swap rates can give any saving. This is shown in Figure 7.19 (see also Table 7.13).
Figure 7.18 EUR two-year swap rates versus actual realised rates
Swap rates Average Libor
%
Note: points 1–5 correspond to data in Table 7.12.
Table 7.12 EUR two-year swap rates versus actual realised rates (%) shown in Figure 7.18
Point Date Saving (%)
1 02/08/1989 1.7
2 07/01/1994 0.2
3 13/05/1999 1.1
4 13/06/2003 0.1
5 27/0620005 0.8
Table 7.13 EUR five-year swap rates versus actual realised rates (%) shown in Figure 7.19
Point Date Saving (%)
1 31/07/1989 1.5
2 07/01/1994 −1.1
3 29/04/1999 0.0
4 13/06/2003 0.2
5 25/03/2005 0.2
If this is the case, it looks reasonable to hedge only at strong minimums, and only for lower durations.
HOW TO IMPROVE YOUR FIXED–FLOATING MIX AND DURATION
Figure 7.19 EUR five-year swap rates versus actual realised rates
Jan
Swap rates Average Libor
Note: Points 1–5 correspond to data in Table 7.13.
RECOMMENDATIONS
We suggested two alternatives to JSCOM (Figures 7.20 and 7.21), which use the current short-term rates by doing the following.
Figure 7.20 Swapping into shorter term fixing 50
Proportion of debt (%)
1 2 3 4 5 6 7 8 9 10+
Reduced duration Current strategy
Duration (years)
Swap JSCOM’s debt into lower duration
1. Swap JSCOM’s long-term fixed debt into floating debt, in order to stop paying the high expected carry on it.
Figure 7.21 Swaption strategy
15-year swap rate increase
15-year swap rate decrease
Swaption matures
in-the-money and is exercised.
JSCOM then moves into floating debt at current rates.
Swaption matures out-of-the-money. JSCOM uses the 0.64% premium and lowers its interest cost.
Sell 3m OTM 15y payer swaptions
2. Swap the resulting floating debt into shorter term fixed debt now, in order to benefit from the current historically low rate environment.
3. Leave JSCOM’s medium term fixed debt as it is, as over time this will become the short-term fixed debt.
Use swaptions in order to float JSCOM’s debt
An alternative for moving JSCOM’s fixed debt into floating is by selling short-dated (under three months) out-of-the-money (OTM) payer swaptions on long duration swap. This process would allow JSCOM to monetise their move to a floating rate in the following way.
1. JSCOM sells a short-dated receiver swaption, with the under-lying swap duration of its longer maturity debt (15 years). The options are struck out of the money, at 4.00%, where at the time of writing the current 3-month into 15-year forward swap rate was 3.78%. This would allow JSCOM to receive an upfront premium of 0.64%.
2. There are two possibilities.
(a) If the 15-year rates are above the strike at the maturity date, the option buyer will exercise the option and move JSCOM’s debt into floating. Since it is our strategic rec-ommendation for JSCOM to reduce its duration, this will fit nicely with the strategy, but will also allow JSCOM to benefit from the option premium.
HOW TO IMPROVE YOUR FIXED–FLOATING MIX AND DURATION
(b) If the 15-year rates are below the strike at the maturity date, then the option expires worthless. JSCOM then just pockets the premium for the option, and may do the same thing again.
The reasons why the swaptions are short dated are to
• give JSCOM an option to actively manage the transition to floating, and
• avoid designation as non-hedge accounting.
Since JSCOM reports its earnings quarterly, it does not have to have any earning volatility if the swaptions are sold and expire within the quarter.
The options are struck OTM so that the transition is slow. In this way, as the swap rates rise, more and more of JSCOM’s debt will move to floating, and perhaps be swapped back into shorter maturi-ties. The change, however, will not be sudden. Moreover, swapping the debt into floating when rates rise will allow JSCOM to lock in a better spread over floating for its debt.
JSCOM was interested in executing the recommendations above, but asked us for further information on the effect this would have on its share price. This further analysis is presented in Chapter 8, on the effect of the duration policy on company valuation.
CONCLUSION
In this chapter we discussed one of the questions most often raised by companies: “What is the optimal fixed floating composition of our debt?”. We proposed measuring the cost of fixing via the concept of the “swap premium” and analysed this parameter over history for various swap maturities.5Shorter maturities seem to offer a better risk–return profile, and we used this in order to obtain the optimal proportion of debt fixed for various maturities. In the next chapter we shall look into the risk and compare the risk increase with the reduction in interest cost.
1 Using swap rates and Euribor rates from January 3, 1989, to January 5, 2010. Data before the introduction of the EUR is based on Deutschmark rates.
2 This is because the premium for higher tenors is difficult to calculate due to insufficient data.
3 For example, the first 10-year period starts on January 1, 1989, and ends on January 1, 1999.
The second period starts on January 2, 1989, and ends on January 2, 1999, and so on. The last period starts on January 1, 1999, and ends on January 1, 2009.
4 There is a small difference here between the saving shown earlier of 1.35% and the value of 1.35% in Table 7.9. This is due to slightly different observation periods.
5 Even though in this chapter we have focused on the EUR rates, we have performed the same analysis for companies in USD, GBP and AUD, and obtained very similar results.