§2.5 Choice of hedging instrument

The hedging instrument of choice in PFI projects for LIBOR-based bank loans has been, almost universally, interest-rate swaps. This pattern has arisen for two reasons:

- the desire on the part of all concerned (the Authority, the Contractor and the lenders) to keep the hedging strategy as simple as possible by using a single instrument which can hedge the entire loan over its full maturity; and

- the liquidity of the swap market, particularly at longer maturities, where the availability of alternative instruments tends to tail off and so their pricing tends to become more volatile.

Nonetheless, despite the near ubiquitous use of swaps in PFI deals to date, this should not be automatically accepted by the Authority, and their financial advisers should assess this decision when preparing the ITN and again later when evaluating bids.20 Interest-rate swaps (and some other financial instruments) can carry large breakage costs if they have to be terminated prematurely, which the Authority is liable to pay in some termination scenarios (i.e. Authority Default or Voluntary Termination, Force Majeure Termination, or Termination for Corrupt Gifts). Moreover, the implications of these contingent liabilities is not limited to termination scenarios and may impact on the Authority's flexibility to change its service requirements during the life of the PFI Contract on terms representing value for money. Although large breakage gains are also realisable on premature termination, e.g. if market assumptions about future interest rates have increased, it is the contingent costs in particular which should be assessed within the Authority's value-for-money analysis.21

Proposals from a Contractor for the Authority to accept 'standard' hedging market terms should always be questioned. The fact is that there is more than one standard. The hedging market generally uses ISDA (International Swaps and Derivatives Association) documentation. Authorities should be aware that there are various methods under ISDA documentation for calculating breakage costs, and it is important that an objective (market price-based) measure should be used. This means that if the ISDA 1992 Master Agreement is used, the 'Market Quotation' rather than the 'Loss' payment measure should be used.22 The ISDA 2002 Master Agreement offers only one payment measure ('Close-out Amount'), which generally requires a determining party to consider market quotations and other market information but offers greater flexibility than the Market Quotation payment measure if that information would not produce a commercially reasonable result.

The question of breakage calculations is also relevant in considering the potential for the Authority sharing in gains from future refinancings. Refinancing is a scenario affecting the Authority where termination of the swap is not tied to termination of the Project Agreement (that is, termination of the swap is discretionary on the part of the Contractor).23 In this context, particular note should be taken of the treatment of the swap credit premiums within the calculations applicable under the chosen form of documentation (see §4).24

Viable alternative strategies to sole reliance upon swaps are regularly used in the private sector and should be evaluated for their value for money on a project-by-project basis. One of the key differentiators between products used in the corporate treasury market is whether or not there is 'optionality' within the instrument. If there is, this effectively means that the Contractor can choose whether or not to take advantage of some form of protection against rising interest rates. The fact that the Contractor will benefit if rates fall instead, means that there will normally be an up-front option purchase cost, which would have to be funded by the Contractor. The principle of always buying hedging instruments under competitive conditions is doubly true of option based instruments because of their often bespoke nature and relative illiquidity, particularly for the longer dated maturities inherent in PFI projects (cf. §2.7).25

Relevant interest-rate products used within the corporate treasury market include:

- interest-rate caps, under which compensation is paid if interest rates rise above a specified level. This is in effect a series of options ('caplets') pursuant to which the hedging counter-party pays an amount (if any) calculated by reference to the amount by which the market interest rate exceeds the cap rate on particular dates.

- interest-rate collars, under which compensation flows if rates move outside a defined band.This can provide both some upside and downside potential to the Contractor. The 'collar' is constructed from a cap (as above) and the opposite transaction, a 'floor'. If rates rise above the cap the Contractor exercises its option rights under the cap; if they fall below the floor the bank exercises its equivalent rights under the floor to impose a minimum level of interest payments on the Contractor. Depending on how the rates are structured, it is possible for a collar to be nil-cost at the outset, i.e. the cap and floor are each worth the same amount (one being bought and the other sold by the Contractor, they net-off to a nil cost). Since this product involves the Contractor writing an option (i.e. the floor) it is sometimes regarded as a higher-risk product than a swap.

It should also be remembered that swaps which become effective at Financial Close may not involve potential payments between Contractor and its swap counter-party for some months (or longer); that is, swaps can have a 'delayed start' date (if necessary for a period of years) so that the hedge protec-tion matches precisely the expected draw-down and repayment profiles of the loan being hedged.

Setting aside issues of competition (cf. §2.7), pricing for these option-based products is closely linked to that for interest-rate swaps. One advantage of a product where payments are only ever made from the counter-party to the Contractor is that they create limited credit risk for the counter-party (i.e. the counter-party is not relying on the Contractor's ability to pay further amounts beyond the option purchase price); this applies to interest-rate caps but not to collars which do involve potential credit risk for both parties. So whilst the use of a process which ensures competitive pricing is more impor-tant the more unusual or complex the product, the lack of credit risk for a counter-party should create a much larger potential pool of providers and so greater scope for an open market competition for these hedges. Balanced against this is the fact that the total market for such instruments is generally smaller than for interest-rate swaps.

The skills required to provide expert advice on interest-rate hedging strategies and execution will not always be found within the firm chosen by the Authority to provide all the other aspects of financial advice required. Where they are not available, the Authority should consider also appointing (or its financial adviser appointing as a sub-contractor) a hedging market participant, or specialist consulting firm which is close to the operations of the derivatives markets, to supplement the expertise of the financial adviser. The Authority's legal advisers should also have the necessary experience to review the ISDA documentation.

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20 Whether in response to an ITN, or as part of a funding competition carried out by a preferred bidder.

21 The remainder of this section deals with breakage costs under hedging for bank loans. In the case of bonds, where a 'Spens' clause may apply, cf. Office of Government Commerce: "Guidance on Certain Financing Issues in PFI Contracts" (July 2002), Section 2: Using the Capital Markets for Finance, §2.12.

22 Except where the hedge provider is hedging on a back-to-back basis, i.e. a 'fronting bank' structure is being used (cf.§2.7, §4 and Appendix 1), in which case the Loss method is justifiable (with Market Quotation being required in the underlying back-to-back swap). Note also that if, at the relevant time, no Market Quotation is available (because there is no market) then the calculation reverts to Loss automatically.

23 It is important, in discussion concerning possible Refinancings, that steps are taken by the Contractor to ensure that any potential conflicts of interest arising between Contractor, lender and swap counter-party are properly managed on an arm's-length basis and any new swaps dealt with as set out in §2.7.

24 It is also possible to arrange for swap documentation to include break-point dates, over the term of the swap, on which the party taking out the swap (i.e. in this case the Contractor) may elect to terminate the swap without potentially incurring termination liabilities. This flexibility will inevitably come at a price, but if the break-point date is coincident with a Refinancing or a planned major change of the PFI project, it could nonetheless offer good value for money.

25 The value-for-money assessment of all hedging instruments necessarily extends to their full range of economic characteristics, including potential termination liabilities and accessibility of a liquid secondary market for their disposal etc.