Hedging your bets in an uncertain world
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Hedging your bets in an uncertain world Decision support for ECGD'S interest-rate swap exercise
Denise Dyke, Chris Woodward and Tim Sharkey Figure 1: How a swap works
In 1986 the Treasuty Management Unit (TMU) of the Export Credits Guarantee Department (ECGD) carried out one of the biggest interest rate-swap exercises undertaken as of that date by a single organization. ECGD's Operational Research Seivices (ORS) built a
PAYS FIXED RATE
ECGD
Constant Notional
computer model to analyse over 400 loans and to identiIj possible swaps. The successful implementation of this model led to a member of ORS being seconded to TMU
Amount
COUNTERPARTY
to develop the model further and to investigate other areas where ORS could provide help. This was the first time such a secondment had taken place, and both
PAYS MARKET RATE
clients and ORS benefited from the arrangement.
ECGD uses the swap to 'hedge its position, i.e. to protect it against the danger of future fluctuations in
Background
market rates of interest. Figure 2 shows the impact of a swap on ECGD's cashflow.
ECGD is a government department which insures
exporters against bad debts arising from approved export transactions. For capital goods exports sold on credit terms in excess of two years, it also supports the provision of fixed-rate export finance. Such finance is provided by
Figure 2: Hedging interest rates Loan
banks in the United Kingdom who, subject to ECGD
BANK I
approval, make loans available at internationally-agreed
fixed rates of interest.
SWAP
Since fixed-rate funds are not
(MRFR) on loan plus margin
and since the internationally-agreed interest rates are
frequently below prevailing UK rates, ECGD assumesthat
Pays MR
ECGD
banks will fund themselves on a floating interest-rate
EXPORTER
on loan
Pays IMU
readily available ¡n the UK, especially for loans which are drawn down and repaid progressively over many years,
Pays FR = 8%
on swap
Pays FR =9% on swap
SWAP COUNTER PARTY
basis and offers compensation for the difference between the cost of floating-rate funds (measured by reference to
-k = Cashf low; MR = Market rate; FR = Fixed rate
interest charged to borrowers.
Net cost to ECGD 1% plus margin whatever the market rate
LIBOR) and the internationally-agreed fixed rates of
The Department thus operates an interest-rate stabilization programme, paying or receiving (as
In this example ECGD has a net IMU cost of 1% plus
the bank's margin which will not vary with time, thus achieving one of the principal objectives of the exercise,
appropriate), the difference between the floating-rate cost
of funds to the banks and the agreed fixed rate.
Historically this has tended to result in ECGD paying
namely to introduce certainty into the cost of meeting ECGD's IMU commitment, irrespective of subsequent
programme is often referred to as an interest make-up (IMU) programme.
The swap programme
movements in short-term interest rates.
significantly more than it receives, and for this reason the
ECGD had neither the vires nor
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