If your firm is in the habit of using over-the-counter (OTC) products to hedge its exposure to interest rate change and foreign currency fluctuations, now might be a good time to consider exchange-traded instruments, such as futures and options. While OTC products have a role in many companies’ hedging programs, so do exchange-traded products, says Marcus Katz, director of interest rates products and services with CME Group. CME is the organization behind the Chicago Mercantile Exchange.

Granted, CME is in the business of exchange-traded products, so Katz has an interest in promoting them. However, the products have a few things going for them in today’s environment. For starters, they can be less expensive than products found in the OTC market. Just as important, given growing concerns over counterparty risk, companies whose hedging transactions that take place via an exchange are made whole if the other party defaults.

Some CFOs may favor OTC products because they can be customized to a specific transaction. Exchange-traded products are standardized and thus by definition aren’t custom. However, it’s not unusual for a company to combine a couple of products to more precisely match their hedging needs, Katz notes.

What’s more, finding cost-effective ways to guard against interest rate risk is key for the many midmarket companies that obtain much of their funding through floating rate bank loans rather than in the public debt markets, where they would get fixed rate coupons, Katz notes. These firms need a way to hedge their exposure to interest rate fluctuations.

In a white paper, “The New Environment and Financial Risk Management,” Katz calculates the costs of a hypothetical transaction in both the OTC and exchange-traded market. Say a corporate treasurer wants to hedge the firm’s exposure to a floating interest rate on a $100 million, three-year loan. Its corporate cost of funds is LIBOR plus 2 percent. The initial OTC credit charge is 10 basis points. So, using an OTC swap, the company’s cost of hedging is 10 basis points * 100,000,000 * 3 years = $300,000.

Now, assume the firm instead turns to Eurodollar futures. The initial performance bond, or the money that goes to the clearinghouse as protection against the risk that the firm goes bankrupt, is $39,600, and the variation margin is $157,500, calculated assuming a worst-case scenario, with interest rates falling to 0. Even so, total costs are less than the OTC costs by about $100,000, or $300,000 less $157,500 less $39,600.

While exchange-traded products won’t replace all OTC transactions, treasurers concerned about both costs and counterparty risk will want to consider them as part of their hedging tool kit. ###