Dominion Gas Holdings, Llc Anticipatory Interest Rate Hedging Case Solution
At the start of the year 2006, Dominionâ€™s operations have a mix of highly regulated utility and the exploration and production of oil and gas resources. At that time, the share value of the company was too low due to the different perspective of their two types of investors. The investors who invested their money in regulated utility wants the stable cash flows while the investors who invested their money in oil and gas exploration and production wants to take more risk and increase in investment in exploration and production of oil and gas. In order to overcome these problems, company has decided to focus just on regulated electric and natural gas transmission and distribution for the purpose to produce the consistent and highly acceptable earnings for the investors to increase the earning per share growth and market price of shares.
Consideration of Forward Start Swap:
The reason behind the consideration of a forward start swap, is to protect the debt against the changing in yields on United States treasury bonds before one year of debt issuance. Because the established yield for the issuance of actual debt belongs to the yield of United States treasury bonds along with the expansion of companyâ€™s credit and the issuance of new concessions. Dominion Resources wanted to hedge the risk associated with its new debt issuance of 1 billion United States dollars planned for the year 2013.
The financing costs are unknown for the company at the time of debt planning in November 2012, because the coupon rates are not identified for the issuance of 1 billion United
States dollar debt in November 2013. That is why Dominion Resources wants to enter in forward start swap in order to lock the future financing cost which will be occurred after one year of the day of planning. For this purpose, company wants to enter in a number of forward starting interest rate swaps as a pre issuance hedging tool which might lead towards the some accounting and regulatory risks for the company along with some other utility companies who have choose not to hedge at all.
For this consideration, the bank had approached the Dominion Gas with the suggestion price for the 3 year forward starting swaps of 0.7 percent at the beginning of November 2013 and ending of November 2016. Dominion Gas wants to decide whether it was a fair rate or not. For this, Dominion Gas has willing to engage in the forward starting swap against the overnight index swap (OIS) rate instead of LIBOR.
Floating Forward Interest Rate Swap:
The forward interest rate swap would be a floating rate receiver which will be based on the three month LIBOR rate plus a fixed rate of making coupon payments upon the dates that have scheduled for the three year senior debt note. Moreover, the fixed notional principle for this floating rate forward swaps is 250 million United States dollars for which the company is trying to find out the fixed rate that could be set on November 2012 for November 2013 debt issuance by using the forward starting interest rate swap.
Locking of Fixed Rate Interest Expense:
As known that the forward interest rate swap is a derivative contract which takes place by exchanging the cash flows or liabilities between two parities from two different financial instruments. So, it is the strategy to fixed the interest rate expense for the company in that flexible way with whom the company can easily meet with its investment goals by hedging its variable rate of borrowings because the interest rates in the economy are low but are expected to rise in future in an unstable way for the business at the time of their liquidation.
In order to lock the floating rate interest expense into a fixed rate interest expense by making the exchange of interest payments between the borrower of the swap and the lender of the swap (these two parties are not exchanging the principle amount of the loan but exchanging the cost of borrowing of the loan).
By using the forward starting interest rate swap, the borrower pays stagnant interest payments at variable rate on the loan in every quarter. For some loans, it is resolved by LIBOR in addition to a credit spread. At that point, the borrower makes an extra installment to the loan which are dependent on the swap rate. The swap rate is determined when the swap is set up with the loan specialist and is constant from month to month. At the last, the bank or lender provide some rebates on the amount of variable rate which is determined as the LIBOR part of the rate, so, eventually the borrower pays a fixed rate………….
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