How to Head Off Interest Rate Risk

October 14, 2009 07:00 PM

It's likely interest rates will stay low for at least the next year or two. But as the economy returns to growth mode, some producers and analysts fear demand for loans could rise, and rates with them—especially with huge government deficits requiring funding as well.

A possible answer is to sell Eurodollar time deposit contracts as a hedge, says Strategic Marketing Services' Nate Smith, who has helped several farmers do so. They are based on LIBOR index points, the same as bankers use to determine the interest they charge.

To figure the implied interest, use 100 minus the rate on an annual basis over a 360-day year. That means a rate of 1% is quoted as 99 and a rate of 2.5% as 97.5. The lower the index value, the higher the interest rate (see chart).

Scaling In. "The March 2010 LIBOR is close to 0.6% now; suppose your current short-term interest rate is 3.6% [your bank is charging 3%],” Smith says. "You believe rates may be considerably higher by 2014 and you want to hedge.”

You have several choices: You might sell one contract in each quarter of 2014. Or you might sell nearby contracts and roll them forward as they expire.

"We suggest producers scale in to their desired positions over time,” Smith says. "That raises the chances of catching the move at its start.”

If interest rates rise, your contracts would also rise in value, so even though you pay a higher rate at the bank, your Eurodollar gain would offset it.

Carry Complication. The market already expects an increase in rates, Smith points out. For example, the March 2014 contract implies an interest rate of 4.5% versus the current 0.6%. "This carry [shown in the chart] makes it more difficult to hedge as you get further out.”

That doesn't mean a hedge won't work, however. Suppose you sell one contract in each of the 2014 quarters and interest rates rise 4% across the board (to 8.5% in our example). Each contract increases 400 basis points times $25, which equals $10,000, offsetting the $40,000 interest you owe the bank.

"In fact, I believe that if they do raise interest rates, they will rise faster in the back months than the nearby,” Smith adds.

Your Risk? Using the same March 2014 contract, suppose interest rates stay at the nearby 0.6% rather than March 2014's 4.5%. That would be a 390 basis-point difference (times $25), or $9,750 on the contract.

"A borrower has to weigh all the risks and rewards before deciding on a strategy,” Smith says.

"Based on an economic model, we think 2012 is about where to start,” he says. "If interest is not headed up by then, we feel there will be other economic issues that are far more serious than rising interest rates.”

Quick Facts
> One contract covers $1 million
> Each contract covers three months
> Months traded are March, June, September and December
> They trade all the way out for 10 years
> Each basis point equals $25/contract
> Eurodollar is the single-largest traded futures contract, providing liquidity
> The contract is cash-settled, so you can let it expire without delivery concerns. (Cash settlement is 100 minus the British Bankers' Association survey of three-month U.S. dollar LIBOR on the last trading day.)
> Initial margin is $1,148

Top Producer, October 2009

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