Total outstanding notional of financial derivatives used by non-financial corporations is USD 27 tn
This huge volume indicates the amount of effort large companies expend on their hedging activities. But is there consensus on the best practice when it comes to corporate risk management?
One of the topics which is often discussed is the fixed-floating proportion of debt. Most companies have to decide on their fixed-floating mix but struggle to find the right answer, because there are so many different aspects which have to be taken into account: historical performance of fixed vs. floating debt, cyclicality of earnings and its correlation with Euribor, projected leverage, tactical aspects, etc.
Ten years ago, it was generally accepted that the floating debt tends to cost less than fixed (or in other words that the forward Euribor curve tends to overestimate the realised interest rates). Since the financial crisis in 2007, the swap curves in major currencies have become much lower and flatter than before. How has this impacted the fixed-floating mix of European corporates? Large international investment grade companies tend to be much more fixed than before because many of them noticed that the swap premium (expected difference between the fixed and floating rates) has reduced tremendously. For example, in the 10-year maturity, historical swap premium in EUR used to be above 3% and at the end of 2019 it is well below 1%. When faced with a much lower (although still positive!) cost of protection against the Euribor, many European companies have decided that this cost is now worth paying and have increased their fixed proportion quite significantly. For example, average fixed proportion of total debt among non-financial CAC 40 companies is 71% and among FTSE 100 companies is 61%.
Of course, fixed-floating mix is just one aspect of the interest-rate decision among many others. Having fixed debt for a year and a day is not the same as having it fixed for 30 years. Therefore, companies have to decide on the optimal duration of their interest rate fixing as well as all the other potential pay-outs: capped, collared, inflation-linked etc. In recent years, proportion of companies using interest rate options has increased for two reasons. First of all, the new accounting standards IFRS9 allow companies to amortise the option pay-out linearly throughout the duration of the hedge, and therefore options are no longer exposing the companies to extra volatility on their income statement. Secondly, many companies have realised that fixing rates does not allow them to benefit from prolonged period of low Euribor and have decided to diversify their pay-outs away from purely fixed or floating.
This is just one example from the second edition of the “Handbook of Corporate Financial Risk Management” which was published by Risk books in September 2019. The handbook is primarily directed to Treasurers, CFOs and Risk managers at non-financial corporations. It contains 43 real-life case studies, based on over 700 client projects over 14 years. The book and its companion website www.corporateriskmanagement.org aim to cover both financial risk management and optimal capital structure and cover the following topics: