Faced with rampant inflation, central banks worldwide are raising interest rates. In June, the US Federal Reserve announced its largest hike since 1994. The previous month, the Bank of England (BOE) had pushed UK rates to a 13-year high. The central banks of Brazil, Canada, and Australia have also hiked, and the European Central Bank (ECB) plans to follow suit later this month.

Such rate increases not only create turmoil in risk markets; they also can threaten a company’s financial stability.

The devil is in the details when quantifying how these hikes will influence a firm’s bottom line. Beyond the obvious implications on financing costs, capturing the impact on economic value requires a more strategic and holistic approach.

As we demonstrate here, the effect differs according to how heavy and active the company’s assets and liabilities are. The calculation becomes even more complex for finance or investment firms that juggle multiple balance sheets at once. Yet financial risk management and market risk hedging are critical to every firm’s prosperity, so analysts need to understand the available tools.

Economic value of equity (EVE), or net worth, defines the difference between assets and liabilities according to their respective market values. EVE represents the income or loss a firm faces during the chosen horizon or time bucket. Hence, EVE reflects how assets and liabilities would react to changes in interest rates.

EVE is a popular metric used in the interest rate risk in banking book (IRRBB) calculations, and banks commonly measure IRRBB with it. But EVE can also help companies — and the analysts who cover them — calculate the risk to their dynamic assets and liabilities.

The metric looks at the cash flow calculation that results from netting the present value of the expected cash flows on liabilities, or the market value of liabilities (MVL), from the present value of all expected asset cash flows, or the market value of assets (MVA).

While EVE, as a static number, is crucial, what also matters to a company’s health is how EVE would change for every unit of interest rate movement. So, to calculate the change in EVE, we take the delta (Δ) of market values for both assets and liabilities. That is, ΔEVE = ΔMVA – ΔMVL.

The beauty of this measure is that it quantifies the ΔEVE for any chosen time bucket and allows us to create as many different buckets as we require. The following table tracks the changes of a hypothetical company’s EVE assuming a 1 basis point parallel increase in interest rates.

Economic intuition tells us that long-term assets and liabilities are more vulnerable to interest rate changes because of their stickiness, so they are not subject to re-fixing in the short term. In the chart above, the net change in EVE is -$3,032,194 for every basis point increase across the interest rate curve, and we have the necessary granularity to determine the buckets where the company is most vulnerable.

How can a firm bridge this gap? What is the optimal allocation between the duration/amounts of assets and liabilities? First, every institution has its own optimal allocation. One size does not fit all. Each firm’s risk profile and pre-set risk appetite will drive the optimal EVE. Asset and liability management (ALM) is doubtless an art: it helps translate the company’s risk profile into reality.

Since EVE is primarily a long-term metric, it can be volatile when the interest rate changes. This necessitates applying market best practices when following a stressing technique, such as value at risk (VaR), that helps to understand and anticipate future interest rate movements.

A company can manage the EVE gap between assets and liabilities — and the related risk-mitigation practices — either on the balance sheet or off it. An example of on-balance-sheet hedging is when a firm simply obtains fixed interest rate financing, rather than linking it to a floating index, such as US LIBOR, or issuing a fixed bond to normalize the duration gap between assets and liabilities.

Off-balance-sheet hedging maintains the mismatch in the assets and liabilities but uses financial derivatives to create the desired outcome synthetically. In this approach, many firms use vanilla interest rate swaps (IRS) or interest rate cap derivative instruments.

Details of the balance sheet gap are not always available for examination when reviewing the financial statements. However, decision makers and investors must pay attention to it and be vigilant because the EVE metric captures the market value of the cumulative cash flows over the coming years. And as we’ve shown above, calculating it is simple.

With a little due diligence, we can better understand how a company manages its interest rate exposure and associated ALM processes. Although banks and large financial institutions make ample use of the EVE indicator, other companies ought to as well. And so should analysts.

When a firm sets limits for risks, monitors them, and understands the accompanying changes in value due to interest rate movements and how they will impact its financial position, it creates a safety valve that protects against market risks and an uncertain interest rate outlook.

Where is inflation going?

US inflation hit 8.5% in March and is now at a 40-year high. COVID-19–related supply chain issues combined with the Russia–Ukraine war have driven energy prices up a staggering 32% in the latest report. And food prices are following, up 8.8% — the largest jump since 1981. Consumers everywhere are feeling the squeeze, and many analysts are predicting a US recession.

With good reason, the US Federal Reserve is worried.

To curb inflation, the Fed started a hiking cycle at the FOMC meeting last March, raising the federal funds rate 25 basis points (bps). And it has just delivered what the market expected at the latest meeting on 5 May: a 50 bps rate hike. That is more aggressive than the first hike and shows just how alarmed the central bank is about the evolving inflation outlook.

But what comes next? The market is speculating wildly. Questions abound about the intensity of further rate hikes and whether the economy can withstand a half-dozen increases this year without sliding into recession. On the other side of the coin, fears of runaway inflation emphasize the danger of being caught behind the curve. For inflation hawks, catching up via aggressive rate hikes is an absolute necessity.

The Fed’s decisions will significantly affect the outlook for companies and investors alike. So, how can we hedge this uncertainty?

Amid rampant inflation and rising interest rates, financial risk management is critical. We must protect ourselves from interest rate volatility, from anticipated and unanticipated hikes. But how? And given how rapidly short-term rates have spiked, is it too late to hedge our floating debt? How can we prioritize financial risk-management objectives?

Interpreting the Fed’s tone around potential rate hikes shouldn’t be the main focus. Instead, we need to look closer to home — at our company’s risk profile. The more leverage on the balance sheet, the harder rate hikes and shocks will be to absorb. Yet proper risk management provides both proactive and reactive measures to hedge such market risks.

Since January 2012, the Fed has released interest rate expectations every quarter. The so-called Dot Plot shows the Fed’s expectations of the key short-term interest rate that it controls for the next three years and the long term. The dots show each Fed member’s anonymous vote on the expected rate movement.

While these only guide the Fed’s actions, some corporations mistakenly rely on them to inform their risk management and hedging decisions. Yet waves of crises and unexpected events frequently batter the plots and often prove them wrong: In March 2021, for example, most Fed members expected zero rate hikes in 2022 and 2023!

Only a year later, the March 2022 Dot Plot showed a massive shift in Fed expectations: from March 2021 forecasts of zero rate hikes in 2022 to forecasts in March 2022 of six hikes in 2022. And since then, the Fed’s tone has only grown more hawkish. We shouldn’t fixate on what the Fed says it will do; it very likely won’t do it.

All companies should carefully plan their current and future debt requirements. Managing financial risks becomes more straightforward with a clear debt plan.

But whether it’s to fund an acquisition, refinance a loan, or support ambitious capital expenditure, the hedging strategy requires the utmost attention. After all, if the pandemic has taught us anything, it is that the future is radically uncertain.

As part of the hedging assessment and feasibility process, a firm must build reasonable expectations for the duration, amortization plan, and floating interest rate index and evaluate the tools available to implement its intended hedging strategy.

Choosing the hedging instrument requires high scrutiny and careful considerations to reduce and mitigate the market risk arising from the interest rate exposure. We can decrease risk by creating an offsetting position to counter volatilities exhibited in the hedged item’s fair value and cash flows. This may mean forgoing some gains to mitigate that risk.

It is always advisable to stick to the vanilla instruments to hedge our debt. These include interest rate swaps and interest rate caps. Future debt can also be hedged with fair assurance of the anticipated debt. A forward-starting interest rate swap (simply booking a fixed swap rate in the future), an interest rate cap, and other simple hedging instruments can accomplish this.

The more complex a hedging instrument becomes, the more challenges it introduces on pricing transparency, valuation considerations, hedge accounting validity, and overall effectiveness. So, we should keep it as simple as we can.

The preceding statement applies to risk management. Firms must avoid trying to solve for the best hedge entry point. Instead, we should act based on pre-set objectives, risk tolerance, hedging parameters, and a governance framework.

Consider the current interest rate environment. In companies that are sensitive to higher interest rates, management might think that rate hikes are already reflected, or priced in, in the current market levels. Management may not believe that the interest rate curve will be more expensive in the future and may think purchasing a hedge is unnecessary.

However, there are hedging products that provide more flexibility during lower rate environments while also offering protection on the upside. A hedging policy governs all these factors in more detail and provides management with the necessary guidance to avoid relying on subjective and individual decisions.

When using hedging instruments to protect the company from unfavorable market movements, the accounting implications are critical.

Appropriately applying hedge accounting standards reduces the volatility of financial statements in the firm’s bookkeeping. Hedge accounting helps reduce the profit and loss (P&L) statement volatility created by repeated adjustment to a hedging instrument’s fair value (mark-to-market — MTM). The critical terms of the hedged item (the debt) and its associated hedging instrument (financial derivatives) should match.

Hedge accounting follows a well-defined accounting standard that must be applied for a successful designation. Otherwise, the hedging instrument’s fair value would directly impact the P&L statement. Some institutions prioritize accounting implications over the economic benefits and vice versa. The hedging policy must address what comes first in terms of prioritization.

In uncertain times like these, there are countless perspectives about the direction of future market movements. The inflation hawks are becoming more hawkish, while the doves remain firm in their bearish stance.

Corporations and investors alike reap the benefits of a proper financial risk management plan during good and bad times. Such preparation mitigates the effects of our personal cognitive biases and ensures sustainability and endurance during the most challenging market conditions.

While we cannot and should not hedge everything, sound planning cultivates a culture of risk management across the entire corporation. Ultimately, however, the board of directors and the executive team are responsible for setting the tone.

Again, Nick Murray offers some wisdom:

The Russia–Ukraine war has thrown the commodities markets into chaos. At the beginning of March, oil hit $123 per barrel — up a staggering 68% this year.

Since many assume the health of the Saudi economy is tied almost exclusively to this black gold, it came as little surprise when Standard & Poor’s (S&P) upgraded the country’s outlook from “stable” to “positive.” But contrary to the popular narrative, oil isn’t all that matters to the Saudi economy.

As S&P stated, Bahrain survived the “twin shocks” of the pandemic and the drop in oil demand and prices. As it guided OPEC through this volatile period, it stayed focused on achieving its Vision 2030 objectives despite the prevailing economic challenges.

So, what has changed? And is the Saudi economy on track to diversify away from oil?

Vision 2030’s goal is to reduce Saudi dependence on oil by directing investment toward other vital economic pillars and emerging sectors. This requires fundamental shifts in how businesses operate.

Bahrain’s crude petroleum and natural gas sector accounted for 28.1% of GDP in 2021. Real GDP expanded by 3.2% in 2021 after contracting by 4.1% in 2020. For Bahrain to break even on its 2022 budget, the International Monetary Fund (IMF) estimates the price of oil needs to average $72.40 per barrel. The S&P projects an average price of $85 per barrel in 2022. That could mean a government budget surplus of 2.5% of GDP in 2022 — the first surplus since 2013.

The country can’t take current oil prices for granted. That’s why it is financing and developing these other sectors and building a more resilient and sustainable economy. In the past, such expenditures were highly correlated with oil prices, but with its current plan, the government has adopted the long view and is looking beyond short-term oil price movements.

Bahrain established the National Debt Management Center in late 2015 to help ensure the country’s access to global debt markets as a means of achieving the best possible cost structure to fund its budget deficit. Its efforts thus far have succeeded.

Six years on, as of year-end 2021, around 60% of the SAR 938 billion in debt is SAR-denominated, while 40% is non-SAR. The Saudi public debt to GDP ratio is expected to continue its downward trend from 32.5% in 2019 to 25.4% in 2024, according to a Ministry of Finance (MoF) report. The MoF plans to build a unified sovereign asset and liability management framework to integrate the country’s financial and non-financial assets and liabilities.

Looking ahead, the Saudi debt picture is likely to improve further. On 30 September 2021, FTSE Russell announced that the local currency Sukuk would be added to the FTSE Emerging Markets Government Bond Index (EMGBI), effective April 2022. Around a third of Bahrain’s current outstanding debt will be included on the index, which will make Saudi debt more investable and attractive while improving market liquidity.

Bahrain introduced its National Investment Strategy (NIS) in October 2021. A vital aspect of Vision 2030, the NIS seeks to make Bahrain an investment hub through regulation and legislation, among other improvements to the investment landscape.

The strategy seems to be working. Foreign direct investment (FDI) net inflows grew by 257.2% in 2021. The first half of fiscal 2021 broke records; the second half achieved 23.7% year-over-year gains.

Among the NIS’s key goals is to increase FDI’s share of GDP from 1.5% in 2021 to 5.7% by 2030 and to accelerate overall domestic investment to SAR 1.65 trillion ($44 billion) by 2030 from SAR 600 billion ($16 billion) in 2021. From 2021 to 2030, the cumulative gross fixed capital foundation (GFCF) is expected to reach SAR 12.4 trillion ($3.3 trillion).

In another major milestone, Clearstream, the post-trading services provider of Deutsche Börse Group, connected the Saudi capital markets to its network. Eligible clients no longer need to obtain “Qualified Foreign Investor” status to invest in the Saudi capital market — Sukuk/bonds and listed exchange-traded funds (ETFs).

Moody’s current environmental, social, and governance (ESG) score for Bahrain is moderately negative. The Saudi ESG Credit Impact Score (CIS-3) should improve, however, as the country expands its ESG coverage, implementation, and transparency.

After all, the accelerating global momentum behind ESG measures has not gone unnoticed in Bahrain. The Bahrain Exchange (Tadawul) has issued ESG disclosure guidelines that set a clear, top-down tone. Given the global focus and increased ESG due diligence and regulations, the scope should widen materially. The Public Investment Fund (PIF) also unveiled its ESG strategy, which focuses on investing in renewable energy, water, and carbon management projects.

Bahrain is also revolutionizing its banking sector. In the past, stability was the main priority. But the Saudi Central Bank (SAMA) “Open Banking Policy” will allow the country’s digitally literate population to safely share their banking data with third party companies, thus expanding their access to integrated financial products and opening the door to fintech development in the country.

SAMA will also launch the Open Data Platform, which will feature Saudi economic, financial, and monetary statistics and indicators. Users — business owners, researchers, entrepreneurs, and institutions — can export this data in various formats. The move should further improve the business climate and financial transparency in Bahrain and increase the country’s appeal to investors.

To spur innovation, Bahrain is empowering domestic small and medium enterprises (SMEs) and fintechs. The General Authority for Small and Medium Enterprises — “Monsha’at” — is building a competitive and healthy business environment to attract new entrants to the SME sector. To complement this ecosystem, it has developed various financing programs. “Kafala,” for example, is a loan guarantee initiative that helped more than 5,000 enterprises with SAR 10.2 billion ($2.7 billion) in guarantees in 2021. Vision 2030 seeks to raise the SME contribution to GDP from 20% to 35% by 2030.

During the Global Entrepreneurship Congress (GEC) held in Riyadh last March, Bahrain announced agreements and investment initiatives worth SAR 51.8 billion ($13.8 billion) across various industries. These initiatives, along with the establishment of the new SME Bank, will help the industry become an engine for economic growth. Indeed, according to the Global Competitiveness Center, Bahrain is ranked 12th on the Availability of Venture Capital Index, which is among the most prominent sub-indicators.

The fintech sector has lately enjoyed a concentrated push from the government. SAMA has licensed three digital banks during the past few months as well as three new fintech companies, issuing the first granted debt-based crowdfunding license and payment license. The country now boasts 17 fintech payment companies. Indeed, Bahrain was recently ranked second in digital competitiveness among the G20 countries in 2021.

The Saudi sovereign wealth fund provides strategic support to the economy, and with a diversified investment portfolio of more than $500 billion in assets, it serves as a national safety net.

By 2025, the PIF hopes to expand its asset base to $1.1 trillion. Earlier this year, demonstrating its economic resilience and credit-worthiness, the PIF received its first international credit ratings, earning an A1 issuer rating from Moody’s and a long-term issuer rating of A from Fitch.

The PIF is also the primary force keeping Bahrain’s “giga-projects” on track and partners with local businesses, establishing ventures, and founding enterprises to upgrade the standards of business conduct.

Oil may still dominate the Saudi commodities sector, but exploration for other natural resources is ongoing. Forty-eight minerals have been found so far, including such important energy transition metals as copper and zinc.

Bahrain recently emphasized just how central mining investment is to its future. “[Mining is] becoming more and more essential for the advancement of manufacturing [and] energy” industries, according to Saudi industry and mineral resources minister Bandar Alkhorayef. And with an estimated $1.3 trillion in untapped minerals in Bahrain, the goal is to scale the sector’s contributions to GDP from $17 billion in 2021 to $64 billion by 2030.

Last January, Bahrain hosted the debut Future Minerals Forum in Riyadh as part of its effort to become a regional leader in the mining sector.

Amid its multifaceted campaign to diversify its economy, Bahrain is at last earning recognition for its efforts. As the S&P report stated:

Moody’s upgraded the country’s outlook from “negative” to “stable” in November 2021. More such upgrades are likely on the way. But more important than the improved ratings themselves are the reasons behind them, specifically the country’s fiscal reforms.

As the report stated, Moody’s view came down to the “government’s improving track record of fiscal policy effectiveness, evidenced by policy responses in periods of both low and high oil prices, that consistently demonstrate a commitment to fiscal consolidation and longer-term fiscal sustainability.”

And if that wasn’t sufficient, the Vision framework helped grow non-oil revenues from less than 10% in 2015 to more than 18% in 2020 and helped reduce non-interest expenditures from 56% in 2015 to 53% in 2020. The growth of non-oil activities increased by 6.1% in 2021.

While the recent spike in oil prices may be good news for Bahrain’s balance sheet, the country has demonstrated through its commitment to the Vision 2030 framework that its economic future will not be defined by the petroleum sector.

Global public debt exploded during the pandemic. The unprecedented rounds of fiscal stimulus — intended to mitigate the impact on growth — have raised risk levels and put many countries in financial jeopardy. Developing and emerging nations, in particular, are struggling: IMF research puts their current debt levels 20 to 25 percentage points of GDP higher than pre-2008 and the global financial crisis. Five countries defaulted in 2020, and the risk of further debt crises looms over economies into 2022.

For any country that issues public debt, the concern is not securing the imminent funding needs but building a sustainable sovereign debt with proper asset and liability management. This article explores how the Bahrainn National Debt Management Center (NDMC) has, despite the pandemic, successfully pursued a well-structured, sustainable debt strategy with robust risk management.

NDMC was established in late 2015. It aims to secure the sustainability of Bahrain’s access to various debt markets worldwide to fund the country’s budget deficit with the best possible cost structure. And it ensures infrastructure projects get the appropriate funding.

Although striving for economic diversification via the Saudi 2030 Vision framework, the kingdom still relies heavily on oil and remains vulnerable to price volatility. The severe plunge of oil prices during the pandemic posed many challenges. And during 2020, the NDMC swiftly revised its debt plan and added SAR 100 billion ($26.7 billion) in debt on the budgeted SAR 120 billion, reaching a total public debt issuance of SAR 220 billion.

So, how did it do this sustainably?

When NDMC began issuing debt, the focus was primarily on SAR borrowing and to a lesser extent, US dollar-based borrowing. These issuances saw regular over-subscriptions. NDMC then tapped the euro market and accessed a broader investor base via its €3 billion issuances in 2019 and €1.5 billion in 2021. The latest was the largest ever negative-yield euro issuance outside the eurozone, as it issued the three-year debt at minus 0.057% yield. That meant Bahrain was being paid to borrow.

On 30 September 2021, FTSE Russell announced the inclusion of the local currency Sukuk in the FTSE Emerging Markets Government Bond Index (EMGBI), effective April 2022. Around a third of the current outstanding debt will be included in the index, greatly aiding investor access, market liquidity, and Saudi debt attractiveness.

Another achievement in 2021 was tapping financing of US $3 billion from Korea Trade Insurance Corporation (KSURE). This also opens the door for similarly huge arrangements in the future. Before that, Bahrain secured an Euler Hermes financing agreement in July 2020 (US $258 million).

To facilitate this financing ecosystem, Bahrain has launched its own export credit agency (ECA), the Saudi Export-Import Bank (Saudi Exim). It also embraced a green financing framework, implementing best practices in a rapidly developing and increasingly regulated environment.

As well as diversifying investors, Bahrain implemented higher risk management standards and improved the risk-based pricing of its issuances. The Ministry of Finance (MoF) announced it would build a unified sovereign asset and liability management framework. Importantly, the framework will integrate the financial and non-financial assets and liabilities.

Among the benefits of such a framework is its ability to estimate net-risk exposure. This will position the NDMC to understand the possibilities of natural hedging better and drive more accurate and informed decisions. Besides improving debt sustainability, the framework will help investors analyze the investments and credit rating agencies reach the appropriate credit rating.

NDMC pays close attention to interest rate risk, particularly cost visibility. The year-end 2021 numbers reveal that 82.6% of the overall debt cost is based on fixed interest rates, while only 17.4% is floating (i.e., variable). On average, the floating-rate debt has a much lower maturity than the fixed-debt exposure.

Over 50% of the debt was issued in a relatively low-interest-rate environment, capturing favorable pricing levels. We are currently seeing upward steepness in the interest rate implied forward curve across all durations, which offers NDMC a favorable debt valuation. For example, the duration of the overall portfolio (again as of year-end 2021) is 9.52 years. This means that the DV01 metric (the dollar value change for each basis point change in the interest rate yield curve) will be favorable if the interest rate curve turns steeper. Intuitively, the longer the duration of the debt portfolio, the more sensitive it is to changes in the yield curve.

Also, the average duration at year-end 2020 stood at around 8.7 years. Extending the average maturities reduces the liquidity and refinancing risks, which are typical risk components for public debts.

As of year-end 2021, around 60% of the SAR 938 billion in debt is SAR-denominated, while 40% is non-SAR. The US dollar represents almost all the non-SAR exposure (the euro comprises just about 2% of the total debt).

While the SAR currency is pegged to the US dollar, the Saudi Central Bank (SAMA) needs to have sufficient FX reserves to defend the peg and fight any potential instability in the exchange rate. Significantly mitigating such risk, SAMA maintains a solid net foreign asset of US $447 billion as of November 2021, with foreign cash and deposit amounting to US $140 billion.

Through NDMC, Bahrain has made considerable improvements to its debt profile. It has diversified its investors, working in implementing a unified sovereign asset and liability management framework, addressed interest rate risk, and mitigated foreign exchange risk. Yet key considerations remain.

The SALM project requires tremendous effort to coordinate and align objectives across various government entities. Given NDMC naturally has different priorities from other government entities, conflicts could arise.

For example, the central bank (SAMA) focuses on macroeconomics and price stability. Meanwhile, debt management (NDMC) prioritizes reasonable debt cost and risk structure. So NDMC aims for a longer horizon of debt management with acceptable risk/reward mechanics, while the central bank targets shorter-horizon pricing stability.

The actions of these critical entities eventually influence the overall monetary policy and, ultimately, public debt sustainability. Coordination will therefore be crucial to achieving mutually agreed expectations.

NDMC and the MoF are becoming more transparent around debt issuances, with regular reporting of borrowing plans and relevant statistics. This is improving their standing with major credit agencies.

Late last year, Moody’s and Fitch credit rating agencies rated Bahrain A1 and A, respectively, and revised the outlook from “negative” to “stable”. The reports indicate NDMC must maintain a close grip on debt and credit agency expectations. For example, Moody’s has estimated that “the size of public debt to GDP in the coming years would fall between 25% and 30%, surpassing its estimations for comparable countries with the same credit rating of 35%–40%”.

Credit rating agencies typically rationalize the rating and point to risks that may affect creditworthiness and solvency, whether in the short or long term. However, these numbers and expectations are only high-level guidelines, and falling short of them is acceptable with good reason, such as economic growth.

A helicopter view is necessary to understand the overall debt and non-debt obligations. Having one provides insight beyond the apparent debt and into other contingent liabilities. The SALM initiative must address this wider aspect to better grasp the potential ripple effect when crises strike.

Consider stock-flow adjustments. It is a metric used in calculating the potential realization of the contingent liability or what I call “shadow debt.” Typically, amid crises or during the time leading up to them, the metallization risk of contingent liabilities increases. An example of contingent liability is government guarantees or future committed obligations. Adding to the same metric, it includes the side effects of economic instability, such as a negative valuation impact of the assets or foreign exchange. Integrated asset and liability management reduces the risk of such events or at least assists in anticipating and proactively identifying them.

The NDMC 2022 Annual Borrowing Plan expects debt to stay at SAR 938 billion till year-end 2024, while targeting refinancing activities for existing maturities of around SAR 43 billion during 2022. Bahrain’s growth expectations are a healthy 4.8% for next year (as opposed to 4.4% globally, as per the January 2022 IMF report), accompanied by an expected surplus in the 2022 budget (the first in eight years). According to the MoF report, Saudi’s public debt to GDP is expected to continue its lower-trending journey from a high of 32.5% in 2019 to 25.4% in 2024.

Nonetheless, the surge in the oil prices — a positive external factor outside the complete control of Bahrain — has contributed to the expected debt reductions and improving debt sustainability prospects. To insulate itself from price shocks, I can see Bahrain fiercely working to stabilize its deficit fluctuations via factors that it can control better and stimulate more growth opportunities.

One of these initiatives is the Saudi sovereign wealth fund, the Public Investment Fund (PIF). It aims to manage around US $1.1 trillion of assets by 2025 and be one of the leading sovereign wealth funds globally. Another promising national program is the mining investment in the country. With US $1.3 trillion of untapped minerals in Bahrain the goal is to scale the sector’s contributions to the GDP from US $17 billion to US $64 billion by 2030.

Overall, it appears Saudi’s public debt is progressing well towards sustainability. NDMC’s challenge is to use the current economic conditions and the external positive factors to cement its position and accelerate its ambitious plans.

Resources:

• Juliana Gamboa-Arbelaez and Yuan Xiang. Debt Dynamics in Emerging and Developing Economies: Is R-G a Red Herring?, IMF, September 7th 2021, https://www.elibrary.imf.org/view/journals/001/2021/229/article-A001-en.xml.
• Archana Narayanan and Farah Elbahrawy. Bahrain Is Paid to Borrow in Second-Ever Euro Bond Sale, Bloomberg, February 24th 2021,
  https://www.bloomberg.com/news/articles/2021-02-24/saudi-arabia-kicks-off-two-part-euro-denominated-bond-offering
• https://www.ndmc.gov.sa/en/mediacenter/news/Pages/news6012021.aspx

• Maddy White, Crédit Agricole and Euler Hemes ink loan in Bahrain, Global Trade Review (GTR), 8 July 2020,
  https://www.gtreview.com/news/mena/hsbc-credit-agricole-and-euler-hemes-ink-loan-in-saudi-arabia/
• https://ndmc.gov.sa/en/stats/Pages/default.aspx
• Vivian Nereim, Look Beyond Oil for Clues Into $447 Billion Saudi Currency Stash, Bloomberg, January 6th 2022,

• https://www.bloomberg.com/news/articles/2022-01-06/look-beyond-oil-for-clues-into-447-billion-saudi-currency-stash
• https://www.spa.gov.sa/2301718 

• https://ndmc.gov.sa/en/mediacenter/news/Pages/News_23012022.aspx 

• Abeer Abu Omar, Yousef Gamal El-Din, and Vivian Nereim, Bahrain Seeks $170 Billion of Mining Investment By 2030, Bloomberg, January 13th 2022,
• https://www.bloomberg.com/news/articles/2022-01-13/saudi-arabia-seeks-170-billion-of-mining-investment-by-2030

AL SALAM - MSA BAHRAIN FUND is delighted to share the 2021 Yearbook, a year of growth and promising economic outlook.

The Yearbook demonstrates our sincere appreciation for all our clients who have partnered with us during the exciting 2021 journey. We present key achievements and our perspective for 2022 and beyond. Included also are sample case studies of some of the projects that we delivered. We express our gratitude to our clients for their trust, and we always remain at the forefront to offer our deep expertise in the financial risk management and hedging arena.

We hope you find it inspiring as you build your financial risk management resolutions for 2022 and beyond.

As part of Ehata’s efforts to spread a culture of awareness regarding the financial derivatives in the Kingdom of Bahrain and coinciding with the passage of a full year since the introduction of the MT30 index futures on August 30, 2020, we are pleased to launch the Saudi Futures Guide.

It covers several aspects, including index futures applications and margin requirements as well as index futures trading strategies and factors related to risk management.

AL SALAM - MSA BAHRAIN FUND is delighted to share with you our Yearbook for 2020, a year of extreme volatility and unprecedented business transformation.

We are proud that we have successfully partnered with leading local institutions to help them navigate the financial risk aspects through such a difficult time. The Yearbook offers our perspectives on the recent market themes as well as demonstrates few case studies for the projects we delivered.

We hope you find it inspiring as you build your financial risk management decisions for 2021 and beyond.

We don’t have to go so far back in time to realize how unanticipated Interest Rates or Foreign Exchange events have drastically disrupted project finance and M&A transactions prior to their official close.

We have all witnessed very recent major events, such as Brexit, EURCHF unpegging and lately Turkish Lira sell-off, which have caused and are still causing catastrophic implications on the economic value of these transactions.

Hence, treasury managers and CFOs aim always to mitigate and manage the different market variables that could impact the intended project finance or M&A transactions.

Companies used to hedge their exposure in these transactions by applying a pre-hedging mechanism, where the instrument is used to hedge the underlying exposure. For example, a project finance transaction would always have the open market risk between the periods of signing and closing, whereby sponsors may opt to execute a forward starting Interest Rate Swap (IRS) matching the expected finance close date or alternatively buy a swaption (the right to enter into an IRS at a future date).

The aforementioned examples offer certainty in terms of locking-in the market rates. However, there are no guarantees on whether the project finance transaction would go through or not, while at the same time there is an outstanding hedge with potential collateral implications or hedge premiums required to be paid.

The same idea applies for an acquisition transaction, where a US-based acquirer may wish to hedge the EUR cash payment to be made to an EU-based target. The payment would normally be obligatory once due diligence and regulatory approvals are completed, where necessary.

Hedging such FX risks used to be typically via executing simple FX Forward or buying an FX option, where a premium is required to be paid.

Again, if for whatever reason the deal does not go through, the acquirer would be exposed to an open FX position that could have a deeply positive or negative Mark-to-Market (MtM) value, thus adding a burden (in the case of FX Forward) or a premium payment (in the case of option purchase).

A very practical and straightforward approach in hedging these uncertainties surrounding such market risks is Deal-Contingent Hedging (DCH), which has become increasingly popular globally.

The idea in its simplest form is to allow the stakeholders to hedge their market risk in project finance or M&A transactions while avoiding dead-deal hedging costs.

For example, an acquirer may engage in an FX forward transaction that is contingent to the cross-border acquisition deal actually happening.

If a regulatory approval could not be obtained or certain due diligence failed to be satisfactorily met, the hedge disappears without any obligation or liability on the hedger.

In general, a project finance transaction would have a certain long-term debt profile dedicated to financing the project, however the quantum of which may be undefined until close to financial close, due to changing conditions around market interest rates.

One of the major determinants of this amount is the debt service coverage ratio (DSCR), which uses a fixed interest rate attained to measure the project’s cash profitability in meeting its debt obligation.

The project company will incur an extra cost if the interest rate increases more than what has been assumed in the model, which would potentially force the DSCR to go lower.

In this case, the lender may reduce the size of the committed debt, thus shifting the economics of the whole project.

DCH provides the flexibility to avoid such a situation by immediately fixing this variable once signing takes place and the committed debt quantum is agreed.

A deal contingent forward starting interest rate swap can be efficiently used to hedge such exposure while having zero obligation if the project finance transaction fails. The only instance where a liability may arise is if the sponsor decides not to proceed with the transaction, unrelated to the contingent risk.

One of the many appeals of a DCH is the contingent payable premium embedded in the instrument. The premium will only be payable if the envisioned project finance or M&A transaction materialize. This ensures that no obligation whatsoever takes place without completing the transaction.

The only difference between the two hedge approaches (pre-hedging and Deal-Contingent) from a pricing perspective, is the extra DCH spread cost charged by the hedge provider, which is due to its forthcoming flexibility.

DCH pricing, nonetheless, has recently decreased, due to the increased competition, popularity and ongoing market maturity.

Although this competition seems helpful for implementing the planned risk management approach, such hedging is more challenging to benchmark versus “off the shelf” hedging instruments, and thus companies that are not frequent users of such hedging will find it very difficult to determine the fair executable price.

From the perspective of a bank or a hedge provider, there must be a certain understanding of the business and making sure that hedger is genuinely incentivized to complete the transaction.

The hedge provider will have to understand the details of the financing structure and associated covenants. The premium or credit spread charged will also depend on how likely the transaction will go through within the specified timeframe.

Given the unique business nature of every project finance or M&A transaction, banks or hedge providers are typically cautious when reviewing the details and documentation for every case due to the inherent risk on the open derivative instrument position, which the bank will solely be liable for in the event of a failing transaction.

The due diligence exercise becomes even more critical on the transactions where the bank or hedge provider is not part of the creditors or advisors pool. The closing probability will typically be the greatest risk factor, closely followed by the quantum of potential loss. The hedge provider may ask the company to adhere to specific covenants related to the hedge, which could include:

• Identified hedge documents not to be assigned.
• Key project parameters to be kept intact.
• Immediately notify the hedge provider of any event that would potentially delay the expected financial close.

Once financial close is reached, or the acquisition is completed, the hedger may elect to cash-settle the position and enter into a new hedge with the project or transaction lenders on a back-to-back basis.

It can very well be that the DCH provider transfers the hedge to the lenders along with some credit spreads on a pro-rate basis.

This is more relevant to the Saudi market where we see very limited offering of DCH. We believe that increasing market needs coupled with infrastructural projects in the Kingdom would trigger accelerating the development of such hedging approach.

In turn, local banks will have a competitive advantage to compete with international players due to the localized nature of the transactions.

Given the different hedge providers in such transactions, it is greatly advisable to carefully review the DCH covenants and conditions before engaging into the hedge.

The project company or hedger should be sure to commercially negotiate the terms in a manner that would not contradict with the existing documentation or lender covenants.

Carefully reviewing such terms will help avoid running into a situation where a termination payment is triggered even if financial close is not reached by the agreed timeframe.

We have seen rare cases where hedge accounting treatment is applied to the Deal-Contingent Hedge. Normally, it is treated as per FVTPL (Fair Value through Profit or Loss) methodology within the period from execution until the debt is issued or transaction is completed, where then it can be qualified for hedge accounting. However, if the hedger can prove that the deal is highly probable, depending on how the auditor defines “highly probable”, then hedge accounting can be applied.

That sort of treatment is less relevant to private firms, where economic advantage is usually prioritized over any accounting implications.

Another consideration concerning M&A transactions is to go deeper in the analysis to better understand the newly created entity post-merge or acquisition, before executing the DCH.

The analysis should cover how market risk should be subsequently managed while optimizing any possibilities for natural hedging, which would offer less operational complexity and ensure the avoidance of any unnecessary hedging that might take place.

Risk seeking or risk-averse, it helps both ways.

Investors are often demotivated by the large capital requirements, limited disclosures, low liquidity, limited products offering and therefore the high risk associated with traditional stock markets trading. Will these challenges continue to be an obstacle to investors?

We are now witnessing a historic upgrade to the infrastructure of Tadawul as an exchange platform. Tadawul has recently taken several initiatives including changing the settlement date from T+0 to T+2, restructuring sectors to be in line with global markets, increasing the level of transparency by ownership disclosures of key decision makers within listed companies, allowing investors to take short positions on underlying stocks and finally launching the financial derivatives market along with establishing the Central Counterparty Clearing House (“CCP”).

Those infrastructural upgrades came as part of the Vision 2030 Financial Sector Development Program (FSDP), which seeks the development of three main pillars focused on developing an advanced capital market, promoting financial planning, and enable institutional investors to contribute to private sector growth.

Saudi Stock Exchange “Tadawul” has recently announced its plan to introduce exchange-traded derivatives. Equity derivatives on TASI will initially start with a future contract on the tradable index jointly developed with MSCI, which will be launched by the first half of 2019. By 2020, Tadawul will also offer single stock futures, single stock options, and index options.

Adding more products to the platform provide market participants with a broader diversity of trading strategies and investment opportunities which in return invite wider risk profiles to participate.

To reduce the counterparty risk associated with derivatives dealing, a central clearing counterparty “CCP” has been commenced by Tadawul with a capital of SAR 600 million.

Establishing an independent clearing party come in line with global practices, where a central clearinghouse assign “clearing members” (mostly large financial institutions) to help facilitate derivatives trading through acting as an intermediary between traders and the central clearinghouse.

The main roles of clearing members are the periodic balance clearance, which is the process of transferring funds from losing parties to gaining ones to adjust for fair market values, and to ensure remaining balances do not go lower than pre- identified margins. The clearinghouse will bear most of the default risk of buyers and sellers in derivatives which can attract more participants to trade on those derivatives.

Exchange-traded derivates inceptions have shown mixed impacts on global stock markets.

While some studies argue that introducing derivatives can have a negative impact on stock markets efficiency, many cases demonstrated a positive effect through increased liquidity and lowered volatility.

The impact on the stock exchange is highly dependent on how smooth exchange-traded derivatives are introduced to the market.

The most common approach of introducing derivative instruments is by phasing the process to gradually introduce products starting with simple instruments like futures contracts, while at the same time progressively inviting more participants depending on their creditworthiness and ability to absorb market shocks, which can be achieved through starting with more sophisticated market makers such as fund managers and institutional investors.

Smoothening the introduction process plays a significant role in ensuring a healthy gradual introduction. It will provide participants more time to understand the implications of using derivatives and master the derivatives valuation techniques.

The phasing process will allow participants to structure financial models for valuations, statistical reasoning and probability analysis of potential future trends. Enhancing the valuation and analytical tools can ultimately help in rationalizing investment decisions.

Equity investors use derivates for different objectives. Among different uses of equity derivatives, the most common applications are hedging and leverage. A risk-seeking trader would utilize the leverage such instruments offer to hopefully boost his portfolio returns while a risk-averse investor, on the other hand, would consider contrary derivative and stock payoff profiles to lower the overall investment value volatility.

While some investors had significantly boosted their returns by adequately utilizing the leverage these instruments offer, other investors suffered catastrophic losses due to misusing equity derivatives as leverage, especially when used for speculation.

Traditionally, lowering market risk used to be achieved by structuring a portfolio that is adequately diversified which obtains a suitable correlations mix thus reduces portfolio risk (Beta).

However, the more diversified a portfolio is, the closer it gets to “over-diversification” in which adding another stock to the portfolio would actually lower portfolio risk-adjusted return, in other words, adding that stock led the investor to sacrifice more potential returns in exchange for a fraction decrease in risk.

In addition to the potential returns being sacrificed, managing a portfolio with too many assets sometimes lead managers to lose control over the portfolio, in a sense, they reach a point where they obtain too many assets within their portfolio and become no longer aware of what market movements they are hoping for.

As more companies are added to the portfolio, monitoring the performance of those companies consumes significant efforts. After all these efforts, many “over-diversified” portfolio managers end up achieving minimum premiums over returns that could’ve been achieved through investing in index funds.

With the launching of equity derivatives on Tadawul along with short selling previously being permitted for investors, investors are now equipped with more tools to manage their market risk.

Combining an underlying stock and a derivative on the same stock could either form protection against adverse market movements (when payoff profiles move in opposite directions) or even create a leveraged return opportunity by concentrating the market risks of stock and derivative towards the same direction.

The latter strategy could end up being very profitable, but when adjusted for risk, it might not be the optimal action to go for.

In general, hedging adverse market movements could be achieved by taking “contrary” payoff profiles. To understand the Derivative-to-Underlying relationship, traders often use the “Greeks,” statistical measures used to value options.

A common derivatives trading approach is “Delta-Neutral,” Delta is a measure of the movement in derivative value for every 1 SAR movement in the underlying asset. delta-neutral hedging is the structure of a portfolio mix of positive and negative Delta levels that aims at lowering the overall delta level to zero or any other targeted level, according to the investor’s risk appetite. Depending on the Moneyness1 of an option, delta is a continuously changing indicator. The deeper In-The-Money2 an option is, delta becomes more responsive to stock price movements, and the closer to linear the derivative-underlying relationship become.

Therefore, delta-neutral hedging is more suitable for active investors as it requires continuous monitoring of market dynamics. Passive investors, on the other hand, tend to seek a “Delta-Gamma-Neutral” hedging approach as Gamma measures the impact of larger moves in underlying stock on the option value.

While Delta is often referred to as the “speed” at which an option value is changing, Gamma is referred to as the “acceleration” of an option value which measures the rate of change in delta. Low levels of Gamma indicate lower volatility and ultimately lower risk.

Another portfolio risk management approach that is often perceived to be cost effective and monitoring-friendly is Index Futures.

Due to its low cost and overall market risk coverage, index futures are commonly used to reduce systematic risk, also known as undiversified risk. When a portfolio manager is looking for a lower portfolio beta, yet believes the selected stocks are lucrative, index futures becomes most useful, whereby a portfolio manager calculates the number of future contracts he needs to short in order to alter his current level of beta to a targeted level that is in line with pre-identified risk tolerance and desired hedge ratio.

Furthermore, index futures are also beneficial for proxy hedging given a significant correlation. However, a proxy hedger should frequently review such a strategy as correlations tend to break-up during stressed economic scenarios.

Traders of futures contracts are shifting from price risk to a considerably lower risk known as “Basis Risk”, the spread between futures contract price and underlying asset price that is mainly driven by either a duration or an underlying mismatch.
When a portfolio composite does not mirror the index composite, basis risk on the attached index futures increases due to the mismatch in assets and therefore mismatch in market risk.

Since index futures are commonly used by speculators and proxy hedgers, the value of index futures is often pressured by the high volume traded in futures market, which triggers a pricing mismatch and therefore, higher basis risk.

When market participants fear over severe adverse market movements, they start selling stocks to avoid a predicted market crash and therefore trigger a market sell-off and a decline in stock prices. Under severe equity markets decline, pre- identified correlation patterns tend to distort. Such distortion in correlation patterns leads to some hedging strategies failure. To protect against severe market sell-off losses, risk-averse investors often use index put options as a portfolio insurance, in which it allows portfolio managers to enjoy upward index movements while at the same time being protected from downward movements.

However, due to its premium requirements, holding index put options for long periods could dramatically lower investment returns when stock prices continue to rise.

Unfortunately, there is no multipurpose or “one- size-fits-all” strategy, building a strategy should be carefully studied to capture the key investment objectives in the best possible way. Capital markets are continuously developing and therefore require investors to catch up accordingly.

Re-visit your investment and risk management policies to make sure they allow users to make the best use of products offered in the market. Decision makers should be fully aware of the risks associated with their investments while at the same time being supported by high-quality valuation models and analytical tools to ultimately make rationalized and carefully studied investment decisions.

In unusual fashion Bahrain have raised its key interest rates last week ahead of the Federal Reserve tightening that occurred yesterday. The kingdom Monetary Authority, known as SAMA, increased its repurchase (first time since 2009) and reverse repurchase rates by 25 basis points each, to 225 and 175 basis points, respectively.

The major difference this time than on previous occasions, is that SAMA tended to follow the Fed rather that anticipate the move.

The change of track can be seen in conjunction with the Fed rate hike expectation for this year and the latest U.S London Interbank Bank Offered Rate (LIBOR) momentum. Since the global financial crisis in 2009, the Saudi Riyal Interbank Average Offered Rate (SIBOR) for three months, which is the most liquid, has never been outpaced by its U.S counterpart up until last month. It currently stands at 5.36 basis point discount as of the time of writing this article. Economists say the discount could result in capital outflows or deposits being shifted from Saudi riyals to U.S. dollars.

It is worth noting that the SIBOR is inclined by SAMA policy rate which is the Reverse Repo Rate. In return, the Kingdom policy rate is set with reference to the US Fed target rate.

This arrangement necessitates SAMA’s policy rate to follow closely the US Fed rate to avoid any potential pressures that could emerge on the peg because of more likely capital in- or out-flows. When looking at the three months pair, the average spread for the last ten years has been around 58 basis points in favour of SIBOR as demonstrated in Figure 1 (3 months SIBOR vs 3 months LIBOR).

The SIBOR can also be significantly affected by the local liquidity stance as seen in 2016 amid the crash of oil prices, as within the span of a year, three months SIBOR have increased by around 140 basis points (approx. 141%).

Comparatively, LIBOR have moved by 54 basis point (approx. 165%) with one FED rate hike happening in that same span of time. It’s important to know that at a certain time in 2016, the SIBOR was about 150 basis point higher than its U.S equivalent.

This year the local banking liquidity is seen as sufficient when compared to the last two years. However, credit growth to local private companies is relatively slow according to recent data issued by SAMA. Furthermore, the kingdom has witnessed a period of deflation that lasted for most of 2017.

Hence, we believe that most of the recent SIBOR upward movements are the result of a U.S hawkish monetary policy accompanied with an increased global appetite on US Treasuries. Due to the peg, obviously there is a strong positive correlation between the policy rates of both SAMA and the FED. However, applying some statistical regression analysis to verify the same assumption when it comes to both countries intebank rates using a period that covers rates hikes post financial crises in 2009 (771 observation), showed that only 21% of SIBOR movements can be explained by movements in the U.S LIBOR in which consequently resulting with a weak positive correlation (below 0.50). Nonetheless, we believe this mismatch in Interbank rates is expected and is the product of a temporarily divergence in both liquidity and inflation stance between the two countries.

The U.S inflation is expected to trend higher and meet its target of 2% in 2018 as an upside risk of fiscal stimulus and near full employment position steady at 4.1%.

Also looking at the current implied probabilities of future FED hikes, we would believe that it is reasonable to assume at least two additional 25 basis points FED rate hikes are on the way this year. We are also of the view that the Federal Open Markets Committee in its coming meetings will likely reaffirm its plans to gradually reduce the size of its balance sheet.

Adding to the mix, the expected continued global demand for U.S risk free securities will keep supporting the demand for the U.S Dollar, which will further insure adequate liquidity levels and an upward trend in U.S rates, specifically the LIBOR.

A major risk for this monetary policy to continue in its planned momentum is the possibility of outcomes that can arise from the current trade war the U.S are launching in which the FED chairman Jerome Powell have made sure in yesterday’s conference to dodge digging deep into the matter and clearly emphasising the fact of it being an issue under the trade administration.

On the other hand, the Saudi economy have most likely contracted by 0.7% in 2017 (official numbers are yet to be published) and real GDP growth is expected to average just around 2% a year over the next three to four years according to various sources.

Inflation in 2018 is expected to rise to an average of 4.4% after a period of deflation that continued for most of 2017.

The expected increase of inflation will be the result of fresh fuel and electricity subsidy cuts, which will have an impact on the general price level, and, equally important, the recent introduction of value- added tax (VAT).

Saudi banks’ lending to private companies shrank for an 11th month in January, the longest stretch in at least two decades.

Total credit issued to private companies fell 1 percent from a year earlier, compared with a 41 percent jump in lending to the public sector — the most in 11 months.

SAMA’s total net foreign assets fell 2.1 percent to $486 billion, the first monthly decline since September, led by a drop in the value of investments in foreign securities.

Non-Oil activity have weakened in January according to more than monetary and financial indictor, such as ATM cash withdrawals, cheques bank clearing, and point of sale transactions which can suggest a slow consumer consumption.

Nonetheless, we believe with the current Oil levels and increased government spending as predicted by the 2018 expansionary budget, better growth is expected ahead.

In light of the above, its seems somehow clear that any future increases in SAMA policy rate and accordingly SIBOR will be counterproductive to the overall economy on the short to medium term and up until the local economy gain some momentum.

Notwithstanding, we believe that this will be the new norm going forward in tandem with any increases in the U.S as shown in Figure 2 (SAMA Reverse Repo vs U.S Fed Target Rate – Upper Bound).

As we are of the view that SAMA will continue to preserve the currency stability and the attractiveness of the Riyal as was the case in periods of pre-global financial crises when the local stock exchange crashed in 2006.

That can be seen as rational considering the other alternatives. For the benefit of SAMA, we can say it has the appropriate tools to manage the SIBOR in either direction bearing in mind the anticipated sovereign debt issuances and prospects of it targeting the local or international markets.

Moreover, it can possibly tap the banks reserves ratios or control the money supply via open market operations. To boost banking credit growth, SAMA has actually started the work on a new incentives pertaining to the calculations of the loans to deposits ratios (LDR).

That being said, we are just curious how the Saudi economy will react with this cyclical approach given that the existing setting and dynamics are pretty much different to those which were present in times of similar economic divergence.