• The contingent liabilities created by interest-rate and inflation hedging instruments do not cancel each other out. |
If market interest rates go down relative to the rates fixed by a Contractor through hedging, this creates a breakage (unwind) cost on early termination of an interest-rate swap, whereas if inflation goes down it creates a gain on the inflation swap, and vice-versa. It can reasonably be expected that interest rates and inflation would go up or down together, and it could thus be suggested that an inflation swap hedges the Authority's risk of paying breakage costs on an interest-rate swap, and vice-versa, if the PFI Contract is terminated in circumstances where the Authority is liable for these costs.
However, because of the different pattern of termination payments discussed above-i.e. other things being equal, the cost of unwinding an interest-rate swap reduces over time as the loan is repaid, relative to that of unwinding an inflation swap-in reality the argument for mutual hedging is not strong.