Hedge Ratio: a Worked Example

A term loan is approved on a forecast of interest cover and debt service, and every forecast assumes a rate. If the whole loan floats, a rise of two percentage points on US$48m of debt adds US$960,000 a year to the interest bill, and a business that covered its debt service comfortably may not. With three-quarters of the loan swapped to a fixed rate, the same rise costs US$240,000. The lender is not betting on where rates go. It is limiting how far the cash flow it lent against can move before the loan has had time to be repaid.

So a facility, or a separate hedging letter, may require a minimum ratio for a set period after the first drawing, and may also cap it, so that the hedges do not exceed the debt and become a position of their own. The level, the period and the instruments allowed are negotiated deal by deal. Many mid-market loans carry no hedging requirement at all, and leave the choice to the borrower's hedging policy.

The definition decides the answer. The exposure may be the term debt alone, or term debt plus the revolver, which moves every week; it may be the balance today or the balance scheduled at each future date. An interest rate cap usually counts at its full notional, even though it protects only above its strike, and a collar the same. A swap that starts in a year's time may not count until it starts. Some tests are read at each quarter end; others look forward across the required period, which catches a swap that ends before the loan does.

A salmon farming company, constructed for this page, borrows a US$48m term loan repaid at US$6m a year. Its facility requires at least 60% of the term debt hedged for three years and no more than 100%; both levels are the example's, not a market norm. The company enters a five-year swap of US$36m that does not amortise. Beside it is the alternative it was offered, a swap whose notional falls with the loan:

The flat swap starts in the middle of the range and drifts to the ceiling in two years without anyone dealing. In year three the company is paying a fixed rate on US$6m of debt it no longer has. If the swap fixed at 4.0% and the floating rate falls to 3.0%, that surplus costs US$60,000 a year with no loan saving to set against it. A prepayment brings the problem forward:

To come back inside the ceiling, the company must close US$4m of the swap, paying or receiving its mark-to-market on that part. The amortising swap avoids both problems at the cost of a slightly different fixed rate, because its schedule was matched to the loan from the start.

The same words mean something narrower in the accounts. Under IFRS 9, adopted in New Zealand as NZ IFRS 9 and in Australia as AASB 9, a business that chooses hedge accounting designates a hedge ratio, the weighting of the hedging instrument against the hedged item, and it must match the quantities the business actually uses: a company that swaps 75% of its loan designates that 75% as the hedged item, so the accounting ratio is one to one. Tier 2 reporters in both countries apply the same recognition and measurement rules with fewer disclosures, and many smaller borrowers are not required to prepare general purpose accounts at all. Most UK mid-market groups report under FRS 102, whose section 12 sets its own conditions, among them an economic relationship and documentation, without IFRS 9's hedge-ratio requirement. Hedge accounting is optional in all these frameworks.

For a lender the accounting ratio answers a different question: whether the swap's value changes run through profit or through reserves. It does not test whether the loan is protected. A file can show hedge accounting applied and a ratio the facility forbids, or the reverse.

Nor is the ratio the same as hedge cover. In the exporter file Aoraki Trade Exports, hedge cover had slipped from nine months of US dollar receipts sold forward to four. A ratio on the debt would not have shown that slide.

DEFINED IN ONE PARAGRAPH → · OVER-HEDGING → · A SWAP, FROM THE BORROWER'S SIDE →

In the term sheet, the lender asks for a minimum and a period that match how long the forecast is exposed; the borrower asks for room to use caps, which cost a premium but carry no liability if rates fall, and for a ceiling that tolerates the drift of a flat swap. A credit officer reads the swap's schedule against the loan's repayment profile before approving either, because a mismatch there is a breach waiting on the calendar.

After drawdown, the ratio meets the rest of the file. A mandatory prepayment from an asset sale can push it over the ceiling and turn a swap's value into a payment. And every swap uses the bank's own derivative credit limit, so a lender that requires hedging must also approve the line that carries it.

FIXED OR FLOATING → · HEDGING POLICY → · THE ISDA SCHEDULE →