THE SOUTH AFRICAN TREASURER: NEXT GENERATION TREASURY

TMI | THE SOUTHAFRICANTREASURER 35 NEXT GENERATIONTREASURY It is therefore imperative tohave afirm graspon the outlook for interest rateswhen locking inan IRS. Interest rate swaps as a hedge against interest rate risk To hedge against the interest rate risk, companies have several tools at their disposal. The most widely used hedging tool is interest rate swaps (IRS), which effectively allow companies to exchange interest payments on an agreed notional amount for an agreed period of time. IRSs are also used to achieve the desired balance between fixed and variable rate debt. While IRSs are a great tool to hedge against interest rate risk, if implemented at the incorrect time, they can be very costly. It is therefore imperative to have a firm grasp on the outlook for interest rates when locking in an IRS. ETMuses several quantitative models to assess the current economic backdrop while comparing these to current market pricing to understand the potential opportunities or risks effectively. It is worth doing some historical analysis of the problem to understand the question of whether to fix or not. ETM constructed a timeseries of the profit and loss one would have achieved when entering into an IRS contract over the last 20+ years to determine at which point of the interest rate cycle would be most beneficial. Our findings show that the most opportune time to lock in rates is at the start of a rate hiking cycle. However, even then, the trade does not remain profitable for very long when comparing the fixed rate paid over the contract term against the average floating rate for that period. This results from the market pricing in a much steeper rate hiking cycle early on, compared to what typically ends up occurring, owing to the economic impact these higher rates have. When looking at a 2-year swap, our analysis shows that since the early 2000s, entering into such a contract has only been profitable for Fig 4 Profit and loss simulation

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