Can Speculation / Arbitration / Hedging mitigate financial risk for Companies?

Some financial risks can be shared through financial instruments known as derivatives, futures contracts or hedging. For example, exposure to foreign exchange risk can be mitigated by swapping currency requirements with another market participant. Equally other risks such as interest rate risk can be managed through the use of derivatives. These arrangements are usually managed under the common terms set out in the International Swaps and Derivatives Association (ISDA) master agreement.

Hedging arrangements will influence the cost of debt, and the breakage costs to be included in termination compensation. Hedge counterparties, or possibly a hedging bank, will be a party to the intercreditor agreement to formalize the sharing of security and arrangements on default. To the extent that hedge counterparties benefit from project security, in theory their hedges should also be limited recourse. Similarly, if hedge counterparties get paid out if they suffer a loss when they close out their hedge, then lenders will argue that they should share any windfall profits. These issues will be addressed in the intercreditor arrangements.

Derivatives are used in many functions in project finance transactions, including

• Interest rate swaps: To manage movements in exchange rates to convert variable rate debt to fixed rate debt;
• Currency swaps: To manage movements in currency exchange rates; and
• Commodity derivatives: To fix the price of commodities over time.

The offtake purchaser may agree to bear interest rate risk, by indexing part of its tariff to cost of debt. However, such tariff adjustments to account for interest rate fluctuations are unlikely to be applied at the speed at which interest rate fluctuations can arise, creating a mismatch risk. Guarantees and other credit enhancement mechanisms can be used to mobilize fixed rate debt.