Article September 24, 2024 What Are You Really Paying to Hedge? A Deep Dive into Transaction Charges What is the “cost” to hedge? Despite being one of the most asked questions by derivatives market participants, hedging costs are still not broadly transparent or well understood. Brett Morrell Head of Risk Solutions You may be asking “didn’t the passing of Dodd-Frank and similar global regulations make this more transparent”? Evolutions in global derivatives regulations have certainly brought transparency to mid-market rates and total spreads above the mid-market rate. However, understanding how to evaluate the spread from mid-market and determine if it is appropriate or not is still a fundamental challenge for many market participants. This is particularly the case for hedgers that do not post cash collateral to their hedge provider. In this case, in addition to market execution charges, a combination of credit, funding, and regulatory capital charges can be applicable. This combination of credit, funding and regulatory capital charges is commonly referred to as “XVA” charges. Standardized market approaches and models for calculating XVA charges exist, and these calculations should be formally run prior to trade execution. However, possessing a fundamental, qualitative understanding of the key drivers of XVA charges can also be significantly beneficial when simultaneously evaluating different hedging strategies and negotiating trade economics with hedge providers. For example, does it make fundamental sense for a hedge provider to indicate a higher spread to mid based on a change to the hedge structure? Example hedge structure considerations and market inputs that impact transaction charges include: Cash flow profiles – as examples, setting a forward starting date on an interest rate swap has an impact on transaction charges. Additionally, cross-currency swaps and FX forwards are frequently considered as potential hedges of similar exposures but have very different cash flow profiles and, as a result, can have very different transaction charges. Mark to market value – not all trades are executed with zero market value at the time of execution. Off-market trades, either in mark to market gain or loss positions, result in different transaction charges than on-market trades. This also impacts trade terminations. When clients terminate trades with large mark to market gains, there can be sizeable funding charges at termination. Credit profile and priority of payments – end-user swaps are frequently secured by the same collateral and cash flows that secure the loan being hedged. The perceived credit quality of the collateral and borrower and location of payments due to the hedge provider in the priority of payments impact transaction charges. Mandatory early terminations – agreeing to terminate and cash settle a trade prior to its stated maturity date impacts both initial transaction charges as well as potential charges at termination. Implied volatility – increases to market implied volatility can increase transaction charges even if all other terms of a trade are held constant. Derivative Path’s Risk Solutions Group possesses industry leading understanding and expertise in transaction charges stemming from deep prior experience on derivatives sell-side desks and acting as in-house risk management practitioners within the global private equity industry. We partner with our clients to provide education and awareness related to transaction charge considerations as well as direct access to technology capabilities which enable clients to calculate transaction charges independently. Our holistic understanding of our clients’ businesses and risk management needs enables white-glove advisory and technology services. Reach out to start a discussion and ensure you have full transparency and understanding of key hedging considerations including transaction charges.
