The costs to banks for higher capital adequacy requirements are taken into account in the pricing of derivatives.
Due to the tightened banking regulation since the financial crisis, corporate treasuries are exposed to the risk that concluding derivatives can become more expensive. The costs to banks for higher capital adequacy requirements are taken into account in the pricing of derivatives. Nevertheless, many companies are still only passive observers in relation to the management of their derivative portfolios, instead of actively managing their negotiation and risk position. In this article, we show you some ways and options as to how corporate treasuries can reduce their hedging costs through active management of credit risks from derivatives.
Companies usually focus on monitoring counterparty default risks after conclusion of the transaction. This credit risk has two sides: On one side, the credit risk of the bank is borne by the companies; on the other side, the bank bears the credit risk of the company. In managing the derivative portfolio, the two sides should be considered already before conclusion of the transaction. There are numerous ways of reducing credit risks and thereby realising cost savings – we recommend the use of natural hedges and an optimised use of derivatives, with collateral when necessary – in this order.
Natural Hedging involves risks minimising in the course of 'normal' operating activity. A company with a significant volume of revenue denominated in foreign currency has, for example, a natural currency hedge through liabilities in the same currency. In addition to minimising financial risks, such operating decisions can also reduce the hedging volume of derivatives. However, operating hedges are not as flexibly controlled as hedges through derivative financial instruments.
Directives usually provide for hedging of market risks also through the use of derivatives. However, practical implementation of this should take into account the costs (transaction costs, risk premium and margins) and benefits. It is advisable for example to dispense with hedging under a certain limit and to avoid short-term renewals in order to save on transaction costs. Diversification means double advantages for the next big cost factor – risk premiums: firstly, obtaining several offers and thus harnessing the benefits of greater competition leads to generally better rates and lower costs.
Today, this can be done on a standardised basis via trading platforms, which allow for conclusion at the best rate at all times. Secondly, this allows for the default risk priced into the derivative to be managed, which is typically determined by the banks on a portfolio basis. If the new derivative improves the portfolio situation overall (thanks to the opposed risk profile), this could even lead to a risk discount instead of risk premium and thus to a better rate at the corresponding bank.
For credit-intense swaps with long terms and high volumes, credit auctions can be a sensible measure to improve pricing. These derivatives usually contain significant premiums for the long-term credit risk and are thus expensive. Using credit auctions, the trading bank can sell the company's credit risk to a third party and retain only the market risk (see graphic). This can significantly improve conditions for the company, in particular if the potential with the transaction banks available is already exhausted.
Another way of reducing the counterparty credit risks is by concluding bilateral collateral agreements with the contracting banks, as an annex to the ISDA Master Agreement (CSA, Credit Support Annex) or master agreement for financial futures. In doing so, the counter parties agree on a regular exchange of cash and securities collateral in the amount of market value, similar to the margining of clearing obligated derivatives. The credit risk is minimised for both parties with deposited funds (mostly cash collaterals), which can also lead to advantages in pricing. Besides the operating risk arising from regular payments, there are in turn liquidity and interest risks. These risks can be countered using allowances, minimum transfer amounts and longer time periods between the settlement payments. However, in this case the company must accept a certain residual risk in their books.
Market risk management through derivative financial instruments is and will remain an essential task of corporate treasury management. Despite the advantages of hedging, neither costs nor default risks can be ignored. Where the potential of natural hedges is exhausted and diversification has reached its limits, alternative instruments such as credit auctions and collaterals can offer real advantages in terms of risks and cost. However, the selection of suitable measures should always be made on the basis of a cost-benefit analysis and preferably applying automated processes and systems.
Source: KPMG Corporate Treasury News, Edition 70, August 2017
Author: Christian Pfeiffer, Manager, Finance Advisory, email@example.com
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