Is it time to hedge interest rate risk?

Swaps, caps & swaptions oh my

Given the pace of the U.S. economic recovery and the Federal Reserve’s stance relating to maintaining low interest rates for an extended period, it’s no surprise that many commercial enterprises with variable rate liabilities have remained on the hedging sidelines. By waiting until the interest rate rise is more imminent, however, the opportunity to lock in particularly favorable interest costs could be lost. By hedging now, in advance of a prospective change in sentiment, companies would be assured of protection if rates spike sooner than widely expected, while bearing only minimal cost if the inevitable transition to a higher interest rate environment is more deferred. The cost/benefit from hedging now happens to be particularly attractive.

This article examines three alternative hedge contract designs: interest rate swaps, caps, and “swaptions.” With swaps, companies can swap their variable interest payments for fixed interest payments, effectively converting a variable interest rate exposure into a synthetic a fixed rate loan. A cap on the other hand, is actually a series of options that serve to put a maximum or ceiling (cap) on the combined interest expense (i.e., traditional interest expenses, coupled with any cap settlements), while at the same time allowing for overall interest costs to fall if interest rates happen to move lower.

Swaptions are simply options on swaps. For a premium (i.e., the price of the swaption), the swaption buyer has the right to enter into a swap at some date (as opposed to now), if, at that later date, it is opportune to do so. Swaps are entered into with no initial payment between the parties. Rather, for a fairly priced swap, the fixed interest rate on the swap is set in such a way as to assure that, at the trade date, the sum of the present values of the then-expected future settlements under the swap will equal zero. In contrast, both caps and swaptions require an initial payment by the buyer of the contract. Sometimes, with the swaption, that initial value of the contract can be mitigated by having that cost built into the terms of the swaption, so that the initial cash obligation is still zero. This seemingly zero-cost swaption obscures the fact that this contract involves the purchase of an option, and option purchases require the payment of an option premium. If not made as an upfront payment, this cost would be passed through to the buyer by raising the fixed rate on the swap that results from the exercise of the option.

Three examples

Values for all of these three contract prices are dependent on the yield curve as of the date of the valuation, or more directly, on the configuration of forward interest rates that relate to the interest resets that the hedger is seeking to address. For illustrative purposes, let’s assume the objective of evaluating alternative hedge structures on February 7, 2014, with the objective of addressing 12 monthly interest reset exposures tied to one-month LIBOR, say, starting in calendar 2015. Our three choices are (1) a forward- starting interest rate swap, with an effective date of January 2, 2015; (2) a forward starting cap, also with an effective date of January 2, 2015; and (3) a swaption purchased today (February 7) that offers the right to enter a one-year swap, effective January 2,2015.

On the date of the analysis (again, February 7, 2014) the at-market forward starting one-year swap (i.e., the swap having a fair value equal to zero) would have required paying a fixed rate of 0.4420 percent. Thus, by transacting this swap, the hedger could lock in a fixed rate of 0.4420 percent for their funding over the 12 months, starting January 2, 2015—plus any credit spread above or below LIBOR that applied to the original variable rate debt exposure being hedged. (These hedges should be understood to address only the LIBOR component of interest rate expenses.)

This article was initially published in the July/August issue of the Association for Financial Professionals' AFP Exhange Magazine

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