Futures as an interest-rates hedge

Press, 27 November 1986, Page 34

Futures as an interest-rates hedge

With over a year behind us since the New Zealand dollar was floated, some confidence is building up in each one’s ability to handle the vagaries of a floating currency.

This is due to a growing understanding of the behaviour patterns comprising the historical performance of the floating N.Z. dollar.

The major catalyst affecting the behaviour pattern has been the New Zealand interest rate structure. Such structure has shown since date of float that interest rates have been in a delayed downward and volatile trend. Market forces would have led the downward trend but Government economic policy has contributed to the delay and volatility of the structures movements. The downward trend of N.Z. interest rates has highlighted the staggering height of them.

A side effect of this has been an understanding of what is known as the interest rate differential or in simple terms the differences between a specific interest rate in N.Z. and the rate obtained by averaging similar rates of our International trading partners.

To be specific, as at November 7, the rate for five-year N.Z. Government Stock was 16.39 per cent whereas the average rate of five-year Bonds of 10 of our trading partners was 7.71 per cent. This

gives a differential of 8.68 per cent meaning that an investment into N.Z. bonds would yield more than one into bonds of our trading partners.

The result of this differential has been the attractiveness of N.Z. As a place for countries such as Japan, the United States and others to place their investment funds, but an expense to N.Z. exporters who then have to tolerate an appreciating N.Z. dollar as offshore investors put purchasing pressure on it.

Again, the height of N.Z. interest rates has had varying implications for N.Z. commodity traders and exporters. These days, a wool trader would be reluctant to purchase on a speculative basis vast stocks of wool, store it for a long period and then aim to sell it at a profit. The high interest expense included in the funding costs of such an exercise prohibits the viability of such activity especially when international commodity prices are low and margins for traders are thin.

What then can the business person do to offset some of these interest costs? The most obvious is the fund operations with offshore finance. This is now a common occurrence within the N.Z. business community. This has the advantage of lower interest costs e.g. six to eight per cent, de-

pendent upon the source of funds.

Many have found to their detriment, however, that it is not as easy and economic as it sounds. The borrower incurs the exchange risk if no forward cover is taken out. If a forward exchange contract is opened to fix a rate, the combined effect of cheap overseas finance plus the cost of cover will approximately equate the cost of borrowing in N.Z. dollars anyway. So is there an easier way?

Yes there is. The growing futures market in New Zealand is now coming into its own. The daily volume of contracts increases regularly as more and more N.Z. business people start to realise the benefits of hedging risks and exposure on the N.Z. futures market. In addition, the increasing knowledge and expertise of the brokers and traders operating in the

N.Z. futures market is instilling greater confidence in the N.Z. business fraternity of the futures market facilities. Let us look at futures more closely.

A corporate with fluctuating interest costs on N.Z. borrowings could stabilise the cost of borrowing by hedging on futures through either the N.Z. Government stock futures contract or the bank-accepted bill contract.

The expertise required to ensure successful futures activity would necessitate an understanding of N.Z. Government funding requirements and how such funding requirements are highlighted in the regular government stock tenders with the obvious reactions on the Government stock futures contract.

In addition, a knowledge of Government monetary policy and how daily and monthly cash

flows into and out of the wholesale money market by the Reserve Bank affect the call rate and short term rates with obvious reactions on the Bank-accepted bill futures contract would also be beneficial. A working knowledge of these things above and a good relationship with a competent futures broker would ensure the executive charged with overseeing the corporate’s hedging operations on the futures market could report to his or her managing director that the interest bill predicted for this year has remained within budget.

It is now over to the New Zealand business enterprises to act on futures. The more innovative and successful enterprises have acted and have good results to show for it.

Geoffrey McDonnell, futures manager, Mair Astley, Ltd.