t P t P A floating for fixed swap transfers the long exposure to the variable (floating) commodity price from the borrower to the creditor. It is open to the creditor to offset this exposure positions by taking short positions in commodity forwards, futures or options, as appropriate. However, where there are exchange futures in tropical commodities, these extend out up to two years ahead, although they are typically only liquid up to around 9-15 months out.
To hedge a longer dated exposure, it is necessary to roll short-dated positions forward – see Hull (1997, pp.37-8). The cost is roll risk which derives from variability of the futures price structure. Roll risk accumulates with the number of times a hedge is rolled and can become large if short-dated futures are used to hedge a long-dated exposure. So although it is feasible to use short-dated futures to hedge a long-dated exposure, this can be risky12.
An alternative strategy is to take a long-dated forward contract through a bank or broker, but since the latter organization will wish to offset its position, it will face the roll risk and will charge accordingly.
This problem is potentially very serious for fixed strike swaps since the creditor party would assume exposure to the floating commodity price for up to forty years. It would not be practicable to look to offset that exposure either on exchange commodity futures markets or through banks or the commodity trade.
The move to floating strike swaps substantially reduces that problem through automatic offsetting. That is because the exposure assumed by the creditor becomes the difference of the price at each future date to the moving average trend at that date with the result that long exposure to the price at any date is offset by a corresponding short exposure through the moving average13.
Unconstrained Schemes
The repayments envisaged under the commodity swap and swaption schemes substitute a stream of repayments defined as
where we have omitted the commodity import price(s) Q for simplicity of exposition. We may also consider a modified structure in which the repayments are freed from their dependence on the initial scheduled payments S1, S2, … ST; i.e. the repayments become
We refer to this as an unconstrained scheme on the basis that modified repayments are not directly related to the scheduled repayments on the original loan except through the requirement that debt obligations are eventually met i.e. subject only to equation (2). The scheduled loan repayments are reduced to the role of an accounting device to ensure full eventual repayment.
The difference between this proposal and the swap-swaption proposal is important because service on concessional debt remains relatively small in proportion to export earnings. If debt service is to be used as the instrument for stabilizing export earnings, this will involve a significant leverage of the fluctuations in commodity export prices or earnings to generate a noticeable impact on foreign exchange availability in the indebted countries.
Repayments in the unconstrained scheme could in principle take on very large positive or negative values. We believe that concessional lenders will probably wish to put a zero floor on debt serviced in any particular year – i.e. the original loan repayments could be automatically rolled forward but the structure should not entail automaticity in new lending. We incorporate a zero floor in the simulation results we report in section 4.4. For reasons of symmetry, we also cap each repayment Rt(Pt, Pavt) , av at twice the scheduled repayment St14 .
12 Roll risk was a major cause of the Metallgesellschaft hedging loss in 1993 – see Edwards and Canter (1995), Mello and Parsons (1995) and Pirrong (1997).
13 Consider the hedging decision at the start of year t, recalling that the price trend is defined by a four year moving average of the prices from years t-1 to t-4. The creditor has full long side exposure to the floating commodity price for year t, but for year t+1 his exposure if offset by a 25% short side exposure to the period t price through the effect of the moving average. Similarly, his long t+2 exposure is offset by a 25% short exposure to each of the period t and period t+1 prices. In the simple case that exposure is constant at $a up to year T, the net exposure would be $a to the period T price, $0.75a to the T-1 price, $0.5a to the T-2 price and $0.25a to the T-3 price. The remaining exposures are all completely offset. Net exposure is small. In the event that further loans are made on the same basis, even this exposure would disappear.
14 The floor and cap complicate offsetting, but so long as the scheme is defined in terms of a moving average floating strike the net exposure will be small.
By Prof. Christopher L. Gilbert, Prof. Alexandra Tabova
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