Derivatives such as these have received bad
press lately, partially because of highly-publicized cases of
unscrupulous transactions that took advantage of borrowers’ lack of
understanding. When understood and properly applied, however, these
tools can be logical resources that provide strong benefits to
organizations with outstanding debt.
Interest Rate Caps
interest rate cap puts an upper limit on a borrower’s variable interest
rate. The organization with the debt to be hedged pays an upfront fee
to purchase a cap from a financial counterparty. Pricing depends on
current rate movements, on how high the cap is set, and for how long.
The financial counterparty is then responsible for any interest costs
beyond the cap rate, should rates rise that high. All else being equal, a
7% cap set for 10 years will cost less than a 4% cap set for 20 years.
organization retains the full benefit of lower variable rates while
protecting itself from a spike in interest rates above the cap level. A
cap cannot become a liability to the organization (unlike a swap), as it
contains only one-way obligations to the financial counterparty after
the upfront fee has been paid. Therefore, an organization’s credit risk
is not considered in the pricing of the cap. Lastly, if the organization
wants to terminate a cap before it matures, the organization will
receive a payment for the cap’s residual value; the higher current rates
are, the higher the value. Ultimately, a cap is best suited for an
organization looking to minimize its exposure to rising short-term
Interest Rate Floor
interest rate floor places a lower limit on variable interest rates for
a chosen period of time. In this situation, the organization is the
seller rather than the buyer. The financial counterparty pays an upfront
fee to the organization to minimize the financial counterparty’s
exposure to declining short-term interest rates. The higher the
probability the floor will be pierced (the higher the floor), the higher
the fee. An organization will receive a higher upfront fee for a 4%
floor for 20 years than a 2% floor for 10 years, all else being equal.
floor provides the organization a tool to monetize the value of its
variable-rate debt. If rates remain above the floor, the organization
keeps its upfront fee but need not pay anything out to the counterparty.
But in exchange for this upfront fee, the organization assumes an
ongoing liability for the term of the floor. If rates decline below the
floor level, then the organization pays the financial counterparty the
difference between the floor rate and the variable rate multiplied by
the notional value of the floor.
Because the organization assumes
an ongoing liability when selling a floor, the financial counterparty
will consider the organization’s credit profile when pricing the upfront
payment; lower credits will receive lower upfront fees. In addition, if
the organization wishes to terminate the floor early, it will have to
pay the financial counterparty a fee based on the residual value of the
floor (the lower current rates are, the higher the value). Lastly, an
organization selling a floor gives up its access to interest rates below
the floor level.
Interest Rate Collar
common motivation for an organization to sell a floor is to raise cash
to purchase a cap, which creates an interest rate collar which bounds
the organization’s variable-rate debt by the chosen cap and floor rates.
The organization is protected from paying interest rates above the
interest rate cap level but has given up the benefit of variable rates
below the interest rate floor level. Though a collar does not provide
for a fixed interest rate like a swap, it does provide a bounded range
of future interest rate expense, enabling more accurate budgeting and
cash flow forecasts.
collar: This organization has purchased a 5% cap and sold a 2% floor,
which provides the organization with an interest rate collar of 2% to
Interest Rate Swap
hedging variable-rate debt with a swap, an organization agrees to pay
out a fixed amount each month to a counterparty in exchange for receipt
of a variable-rate payment that approximates the organization’s debt
service payment. The organization thereby effectively pays a fixed rate
on its debt. There is no exchange of principal or upfront fee; only
payment of the loan’s interest is impacted.
A borrower can fix all or only a part of the variable-rate debt, for any time period. Additional explanation can be found in “An Introduction to Interest Rate Swaps” from the Winter 2008 edition of The Capital Issue.
Interest Rate Payer Swaption
interest rate swaption is an option to enter into an interest rate swap
at some point in the future, up until a specified maturity date. The
buyer of the swaption (the organization) pays a counterparty a one-time
upfront fee that depends on interest rate volatility, the length of time
until the swaption expires, and the rate at which the swap would be
fixed, known as the exercise rate. If the organization chooses never to
exercise the swaption, its maximum loss is the upfront fee, whereas if
rates rise considerably, the organization can enter into a swap and save
the difference between the exercise rate and current swap rates, which
can be considerable in a volatile interest rate environment.
organization should consider buying a payer swaption if it expects to
issue variable-rate debt within the next few years and it believes
interest rates will increase.
Swaptions can also be used by
organizations that plan to issue fixed-rate debt, as a hedge against
rising interest rates. If interest rates rise, the value of the payer
swaption increases. In this case, the organization could sell the
swaption and use the proceeds to buy down its fixed rate on a
forthcoming debt issuance, issuing bonds at a discount.
interest rates at historically low levels, organizations should consider
the potential impact rising interest rates may have on their financial
profiles. Caps, floors, collars, swaps and swaptions remain an effective
strategy to hedge against interest rate volatility and improve
day-to-day cash flow stability.
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