Last week, I wrote about what I see as a major driver of the recent rally in longs: High interest rates. It was a mathematical and abstract article, and I wouldn’t blame you for inserting a few paragraphs into it, noting the sheer volume of numbers and calculations, and moving on with your life. But if you don’t, hold on to your butts, because it’s time to turn the financial angle up a notch.
The main finding of that previous article was that when interest rates are high, money in the future is worth less in present value, so teams looking at their books in NPV terms will view long-term contracts as a smaller liability. An easy way to think of this is to imagine a team financing an upfront contract by buying and holding bonds to pay each next year of a player’s contract. You have to spend a lot less money today to fund future liabilities than you would have to spend if interest rates were much lower, as they have been for the entire past decade.
However, this is not realistic, because teams do not pre-finance contracts with Treasury bills. They have better things to do with whatever money is sitting around, like buying Real estate developments Or put pressure on senators. Most teams have outstanding debts as well; If they have a large amount of change, they will look for new investment first, then consider retired debt, then consider buying minority owners, perhaps prioritizing buying Treasuries a little higher than setting money on fire.
This is problematic, because a change in interest rates can erode some or all of the value in signing long-term deals. Let’s use the same examples from last week’s article. At the current risk-free discount, Carlos CorreaThe Giants’ deal with the Giants is worth $285.4 million in current dollars. If prices were instead at last year’s levels, it would be worth $320.9 million in current dollars. That’s $35.5 million hit in San Francisco’s books if rates retraced to last year’s levels tomorrow — and interest rates spent much more time in the 1-2% range than in the 3-4% range in the past 15 years.
You can see the problem here: Are these “savings” really worthy of the name if they can evaporate thanks to the uncontrollable and unpredictable swings in interest rates? A long-term contract signed two years ago will look as good on the books now as the Korea deal, and if prices fall back to zero tomorrow, both will look equally onerous in current terms.
But fear not, giants’ balance sheet fans: There is a way around this pitfall. It’s called an interest rate swap, and to explain that, I’ll start with a bond. One useful characteristic of bonds is that their prices change in an inverse relationship with interest rates. If interest rates fall, the price of bonds goes up, and vice versa. If the Giants held enough bonds to pay off Correa’s contract and interest rates fell, the increase in the value of those bonds would offset the current, increased cost of his contract.
Think of it this way: If you bought a 10-year bond today that pays you 3.5% interest, that would be roughly the market price; You’ll probably have to pay close to $100 for it, get $100 when it’s due, and get 3.5% interest each year. But if the overall rates go down a bit, your bond will be worth more, because the 3.5% interest is higher than what you can get on a new bond. If prevailing interest rates are 1.5%, the thing paying 3.5% will get a premium. You can also think of it in a discounted cash flow framework if you want; The present value of receiving a series of $3.50 payments would be much higher if those payments were discounted at 1.5% instead of 3.5%.
One way to take advantage of this is to buy bonds using borrowed money. Imagine, for the sake of this example, that you want to buy $100 of a 10-year Treasury note but don’t have the $100. You come to me and ask to borrow $100 for a year. Within a year, you ask to borrow $100 for another year, and you repeat this process until the bond matures and you pay me.
What is the interest rate I will pay you? If you were just a Joe FanGraphsReader I would charge you more than the risk free rate so this trade will not work for you. You will pay me more money than you will get on the bond. But ah! You’re a shrewd financier, and you’re offering me the bond as security. It’s easier for me – or a financial institution, in real life – to lend money at risk-free rates if they can hold risk-free collateral against it.
Suppose, then, that you were able to borrow this money from me for 10 years, with each 1-year loan carrying the risk-free market rate. We can calculate how much money you will make or lose on this trade fairly easily. On the first day you borrow $100 and spend $100 buying the bond – no profit or loss there. In 10 years, you receive $100 of the bond and pay me $100 – again, no profit or loss. In between interest payments is where the money is made.
I’m doing a lot of simplification here to make the math easier, so this isn’t the way it works in the real world, but imagine interest rates are going down and you’re paying me an average of 2% over your 10 years. loans. Let’s further say that your bond pays 3.5% interest. Each year, you will pay me $2, receive $3.50 from the bond, and make $1.50 in profit. If the average interest rate on these loans is $3.50, you’ll end up flat, paying me the money I made on the bond each year. If interest rates inflate to an average of 5% over the next 10 years, you will lose $1.50 annually.
The expected value of cash flow exchange – the cost of borrowing versus the yield on a bond – comes to zero if you make some rather boring assumptions. Just to put a name to it, this is no risk premium, no specialization, fixed accretion, no transaction costs, and no shaving. The exact meaning of these terms is not currently important. The point is, to a first approximation, borrow money to buy the bond, pledge that bond as collateral, and short-term financing to maturity that won’t cost or earn you any money if interest rates don’t change. If they decline, you make money, if they go up, you lose.
If you think of it this way, it makes a great future cash flow hedge. Worried that interest rates will drop and make the $26.92 million you owe in the short term in 12 years more expensive in today’s dollars? You could theoretically buy some bonds with borrowed money to hedge this risk. If prices go back to their lows, the present value of that payment will increase, costing you some expected value; Your liabilities will have a greater present value than you thought they would. On the other hand, you will make some money on your bond hedge; You’ll make more on coupon payments than you owe in interest payments.
The opposite is also true. If interest rates continue to rise, the present value of those future liabilities will decrease – great! On the other hand, you will lose money from your bond hedge; Coupon payments will not offset interest payments on your short-term borrowing. Put a good weight on your hedge, and you may be completely indifferent to a change in interest rates; You can make enough money if prices fall to make up for any losses in the current value of the contract, and lose enough money if prices increase to make up for any gains.
Just one problem: The list of assumptions you make don’t hold up in real life. Just to name an obvious problem, no lender would do this without what’s known as a hair clip – in other words, if you wanted to borrow $100, they’d ask for $102 collateral. It’s like buying a home and taking out a mortgage. Hard to do without money. Banks, the lenders involved, also charge a fee for the use of their balance sheet. There are payments to deal with, and perhaps no quite dated bonds with coupons and maturities quite right to match the Korea contract; There are all kinds of little problems that will make your hedge cost more and make it less effective.
Fortunately, some intrepid bankers came up with a solution to this problem a long time ago. The overall end goal — some cash flow exchange that can hedge interest rate risk — is something companies have always wanted. The solution, as it turns out, was straightforward: Just sign a contract in which both parties agree to carry out the coupon versus lending portion of the deal, without any actual bonds involved. This contract is called an interest rate swap.
Let’s go back to our previous example. If you want a 3.5% coupon every year for 10 years, I simply agree to pay it to you. In return, you will agree to pay me a variable rate for one year each year. There is no messy use of bonds as collateral, no need to take out an existing loan and purchase a bond, and no need to deal with mismatches between when a bond is due and when a payment is due. We don’t even have to exchange $100 upfront or at the end of the deal. It’s just a simple contract: I pay you a fixed rate, and you pay me a variable rate. In practice, it’s simpler than that; We simply exchange the difference in rates each time instead of paying each other.
How can we know which floating rate to use? It’s easy: we agree in advance on the so-called reference price. They are published rates that reflect general financing terms. The old standard was LIBOR, but SOFR, Guaranteed Overnight Funding Rate, is now mainstream. It’s a rate that the Federal Reserve publishes each day, and it reflects the average interest rate at which people borrow money when they post Treasury notes and bonds as collateral.
It’s really magical. If you’re a large enough counterparty, with a prime broker that gives you access to the world of clearing interest rate swaps, you can get into one of these contracts in no time. You can hedge whatever interest rate risk you want, removing the risk of a long-term contract looking more expensive if inflation comes back down next year. You can also do the opposite. If you plan on Receive Big pile of money in 10 years and you’re worried about rising inflation and rising interest rates, you can enter into an opposite transaction: pay a fixed rate and get a floating rate in return.
I find it hard to backtrack here, because my first instinct whenever I start talking about prices is to babble. I want to tell you about the DV01, or dollar value of a 1 basis point move in prices, the standard measure of risk used across fixed income. I want to tell you about the beautiful concept of convexity, which amazed me the first time someone explained it to me. When you discount future cash flows to the present, lower rates mean that money receivable in the future is worth more now. If you bet on low rates and win, your winnings will be more valuable because they are discounted at a lower rate. If you bet on higher rates and win, your winnings will be lower, because they are discounted at a higher rate. What a sporty ride. I want to tell you about currency-based swaps, bond futures basket trades, and the competing theories on how best to hedge as a swap market maker.
But even for me, that’s a long way off. I’ve wandered here long enough already. If I take away just one thing from this article, let it be this: If a team is worried about a variable interest rate environment ruining their long-term smart contract schemes, they can make that worry go away quickly, and for a very low cost. they. I don’t know for sure which teams use swaps to hedge their interest rate risk, but I’m willing to bet that some, maybe even all of them are. These are large, complex companies with complex financial resources. They plan for the future and make investments whose returns vary based on interest rates. If there is an advantage to be found by issuing long contracts, they will find it. If there is a risk on that edge based on interest rate fluctuations, they will hedge that risk.
It’s really cool, if you ask me: a subtle baseball game that goes way beyond what happens in plain sight every day. It doesn’t really affect who wins or loses in a particular game. It is at best attached to this ocean, in fact. But if you’re like me, you love figuring out how things work, and you love taking apart machines to see what makes them tick. I love baseball first and foremost for what happens on the field. But that doesn’t mean I can’t appreciate all the wonderful intricacies surrounding these ten guys playing a children’s game in their pajamas.