Perpetual Swaps & Derivatives?
A unique product was developed in response to repeated requests by customers for an answer to a problem.
The traditional way of handling such translation exposure was for businesses to borrow in local currencies. During such borrowing, natural hedging will happen. This case study describes the introduction of a currency exchange that was arguably more effective than foreign currency borrowing: the Perpetual Currency Swap. This chapter illustrates the advantages of examining not only the pre-tax but the post-tax impact of handling translation exposures. This kind of off balance sheet hedge can help to minimise balance sheet size and supply a much more cost-effective solution.
About It
Essentially, trade exposure covers the valuation in a firm’s home money of foreign currency receivable or payment. It concerns the evaluation of actual transactions. It’s the sensitivity of the value of a foreign currency denominated asset or liability to fluctuations in the value of the foreign currency related to a firm’s home currency. A UK firm with a large US subsidiary is needed to revalue the US subsidiary in Sterling terms on its yearly balance sheet date. Even if the US subsidiary is extremely profitable, a substantial drop in the US Dollar related to the GB Pound would result in a translation reduction for the UK business.
I do not mean to talk about the advantages and disadvantages of Translation exposure management in detail since there’s still a significant difference of opinion. This chapter assumes that hedging the Sterling value of a capital investment has been considered as a “good thing”. It consequently walks through the background to the development of a novel, elegant, efficient and effective arrangement for hedging such translation strikes — the Perpetual Currency Swap.
Information can be gleaned from many a text book or downloaded on the internet. What I find really valuable, even listening to some dead monotonously read-out address, is my lack of concentration. So often something the speaker states can spark an idea possibly in quite a different area. Frequently the very best financial products are cross-markets products. A frequent place application or broadly understood process in one market can be tweaked to give a revolutionary product in another sector. “Think everywhere” I wrote in Chapter 2: the best way to catch the enormous new IDEA. I do my best thinking at conferences.
To my understanding, the “Perpetual” or “Capital-Hedging Swap” first appeared in the Autumn of 1988 independently from Midland Bank and Charterhouse Bank. Structures with a few similarities were also created by S. G. Warburg and Citibank. The exchange was soon widely available from other banks through dissemination by corporate customers to their relationship banks seeking a better price and also through the motion of bank personnel to other banks.
Termination reasons
There are several potential reasons for the termination of the swap. Reasons include: debate between UK plc and the lender on the margin; total utilisation of the bank’s credit line; lack of a novation clause; UK plc’s disposal of the underlying asset; and UK plc’s capital gains tax (Capital Gains Tax) management.
* UK plc is uneasy about how big this Sterling LIBOR margin and hasn’t succeeded in renegotiating it.
Given that both parties have the right to terminate the swap there’s absolutely not any value in using a fixed margin under Sterling LIBOR. Having a fixed margin the swap could result in being in 1 party’s favour in the roll-over date. The termination provisions could be triggered.
The factor margin quoted by the lender and the bank’s right to terminate can be viewed as major disadvantages to the arrangement. The savings generated through the use of this aggressive one year Forex market and the credit line and capital efficiency of this item should more than compensate. The corporate treasurer, however, should put himself in a position to compute and argue for a reasonable margin.
Credit concerns
* Exchange rates have substantially moved with the US dollar appreciating against Sterling. Whilst the value of UK plc’s US real asset has appreciated, a charge position will have been built up against it and in favour of the lender under the swap.
This could be reflected initially in an increased margin deducted from sterling LIBOR. Eventually the exposure might lead to getting a “large exposure” from the central bank’s eyes with respect to a trade with a small bank. A credit line larger than 10 percent of a bank’s capital base is uncomfortably large whilst over 25 percent is impossibly large.
A termination from the lender for credit reasons should not give rise to a significant issue for UK plc.. A Capital Gains Tax reduction would be generated which may be used within UK plc against Capital Gains Tax gains or carried forward within the business. Be aware that, whilst a financing requirement might lead to a cash outflow, under a longer term swap the lender could have assumed the worst possible outcome over the period and calculated the charge line accordingly. There’s absolutely no point paying for a credit line unless it’s needed. Material adverse change clauses are often very helpful to banks.
* There is not any novation arrangement within the swap. The arrangement through leakage by corporate clients and staff moving from bank to bank soon became common knowledge. With the novelty of this structure gone, the lender ought to be ready to novate all or a portion of the Perpetual swap to another bank with a desire for your credit risk. This would prevent a cash flow or tax occasion for UK plc under current tax laws.
Finally, the Perpetual currency swap’s growth exemplifies, just like the creation of the Break Forward reveals, the tangible benefits in cross-disciplinary teams whether formal or virtual. These products were developed a decade prior to Knowledge management became trendy in management consulting.
