Of Texas Hedges

Questions around use case limits for Term-RFR rates have been raised many times, and we devoted some attention to this topic in my most recent Blog; but whatever policy firms decide upon, there is one very real and practical reason why firms should carefully think about their use.

In this blog I take a look at the question of whether traditional overnight index swap products should be used to hedge term deals? Those with deep derivatives experience should already be aware of this problem since it already arises when LIBOR and OIS products and risk interacts.

Texas Hedges

Most people in finance have heard the expression “a Texas Hedge” without having unduly bothered with a proper definition of the term. Is it a hedge that works only partially? One with known or unknown risk gaps? Is it somewhat ‘cheaper’ than a traditional hedge?

I had always assumed it was a hedge that was unlikely to work as the hedger intended; a kind of Saguaro Cacti where topiary would have been more appropriate! It turns out that I was quite wrong. If you thought likewise, you probably weren’t alone; but you were also wrong.

To share some easily available definitions is reasonably instructive:

Oxford Reference Dictionary - The opposite of a hedge, which is intended to reduce risk. In a Texas hedge risk is increased, e.g., by buying more than one financial instrument of the same kind

Collins Online Dictionary - the opposite of a normal hedging operation, in which risk is increased by buying more than one financial instrument of the same kind.

And while we are loathe to resort to Wikipedia, it does fall into line, defining a Texas Hedge thus: a financial hedge that increases exposure to risk.

Whatever the understanding, most people simply recognise that the term is typically used in the pejorative, i.e., they’re a bad idea.

In BOTH the old LIBOR world and in the post-LIBOR world, there was and is an inadvertent Texas hedge problem that emerges when one attempts to hedge term-rate deals with common overnight index swap products (OIS), and it’s a problem that meets the definitions outlined above; that is, when standard OIS are used to hedge term deals risk is actually increased.

A bifurcated derivatives market (term v OIS)

We have written about the emerging benchmark landscape several times in the past year. This is because it is creating variability and choice in both corporate finance and across the derivatives space. We have also looked at the problem of the basis, liquidity, operational and accounting risk that can emerge when deals and hedges are not like-for-like matched on a benchmark and/or convention basis.

I don’t propose to delve further into any of these topics here, except to point out that where term products (cash or derivative) are hedged with non-term equivalents, basis, liquidity, and operational risk can and typically will, arise. And while we don’t wish to downplay these risks, they are somewhat unlikely to be the biggest risks faced.

While there is an emerging smorgasbord of underlying benchmarks (and thus choice), the risk of Texas hedges emerges when participants attempt to hedge products referencing the emerging suite of term rates, whether in cash or derivative products, with standard OIS derivatives.

In fact, this risk was around well before LIBOR reform ensured it would be revisited; OIS hedges for LIBOR risk have long been known to pose the same issue that I will outline here. The problem has come to greater prominence in the post-LIBOR world because the emerging benchmark choices have created a degree of confusion (and in some cases inertia), and use-case limits may restrict the availability of hedges in ways that were (to us) likely unintended.

I will now turn to explaining the peculiar risk that arises.

Bigger than basis

Imagine a simple situation in which a borrower has chosen to borrow floating under the terms a facility that references a 90-day Term-RFR as distinct from daily compounded or simple RFR. The underlying currency and RFR is quite irrelevant.

The mechanics of the reset feature under Term-RFR are analogous with that which operated under LIBOR, and I will represent the reset risk with individual arrows (rather than traditional swap flow diagrams) to keep things simple:

In this simple example, let us assume that Party-A has an initial risk profile whereby they receive floating rate payments based on a Term-RFR benchmark from some undefined cash instrument at 90-day intervals for one year.

The initial reset, (r1), is the only known reset at the outset. The remaining rates, (r2-4) are all unknown, though market makers can readily imply (price) them if desired/required.

What happens in practical terms when these floating rate receipts are ‘swapped’ for a fixed rate?

Very simply, Party-A agrees to pay floating (the lightly shaded red arrows below), in exchange for the floating receipts (the blue arrows) and in return for this swap they receive a fixed coupon at each payment date. We will denote the fix at a rate of RFIX.

The rates used on both sides of the floating risk produce precisely off-setting payments

But what happens if Party-A is receiving floating payments from a Term-RFR cash instrument? Can they use an RFR referencing OIS hedge to transform their exposure to a fixed rate in the same manner as Diagram 2?

The answer is no, at least not perfectly, and there is a big catch that people need to understand.

The fundamental problem here is well known to professional market derivatives experts; a known forward-looking cashflow reset at R1, is exceedingly unlikely (except by chance) to match an uncertain back-wards looking OIS payment which can only be calculated in arrears (r?). If these did match, every OIS traded would settle with zero cashflows.

Aside from an inability to cashflow match (which introduces basis risk), each progressive OIS stub of the OIS hedge becomes problematic in ways that are not immediately obvious. To make this more obvious, let me use a simple hypothetical scenario to make it clear.

Under a traditional like-for-like swap there is no slippage on either side of the floating rate payment schedule; the fixed rate outcome of the swap is assured:

Note that all the rates here are fictional, not some current or past yield curve.

Under OIS versus Term-Rate there is the potential for theoretically unlimited slippage or gain on the OIS side of the payment schedule.

To keep with simplicity, I will assume that the OIS in-arrears payment made under the terms of the OIS swap is 100 BP higher than that of the fictional term rate. This might be based on a shock market occurrence that appeared after the first reset.

Keeping with simple (I.e., no discounted cashflow) maths, it becomes clear that if simple RFR rates (overnight rates) were to RISE dramatically, the payment required under the floating leg of the OIS hedge (‘hedge’) rises, thus LOWERING the effective received rate of Party A.

The result contradicts Party-A's intended strategy (yield maximisation).

This meets a formal definition of a Texas Hedge

And while I did not expect this simple blog to result in finding a genuine textbook Texas Hedge, it seems we have. The mismatch between hedge and hedged item has INCREASED risk.

Implications?

What are the implications of all of this? Some basic directions seem most appropriate:

For parties that do not run trading books that are able to warehouse such risk:

• Understand your underlying benchmark – e.g., is it fit for your purpose unhedged?

• Understand the product-type and its relationship with the benchmark.

• Understand the use-case limits that might restrict your freedom to engage firms to hedge, and to unwind hedges at some point when doing so might be advantageous,

• Adopt a like-for-like approach to hedge versus hedged instrument where possible,

• Discuss what you’re doing with audit to gain an understanding of their views on accounting treatment.

For service providers:

• Ensure your teams understand the emerging smorgasbord of benchmarks,

• Consider the boundaries of your product suite; a too narrow suite can be problematic,

o   If your corporate finance team is doing term rate deals your customers will surely require like-for-like hedges?

• Develop use-case policies that meet the various licencing and regulatory expectations,

• Take steps to ensure relevant staff understand the dangers of recommending mis-hedging to clients based on a failure to appreciate the important differences between products and the mechanics of how their cashflows are determined.

Or at least put up a big sign in your treasury office – NO TEXAS HEDGING!