Interest-Rate Risk Management: Swaps, Caps, Collars and Hedge Ratios

In 2012, the Bank of England and ECB cut rates to record lows (of the time). For most of the next decade they barely moved. During that time, rates markets persistently priced in “normalisation”, i.e. a recovery from basement level, accommodative central bank rates to a more normal interest rate environment. As a result, forward interest rate curves were upward sloping, and anyone who locked in a fixed interest rate on a loan did so at a higher rate than the prevailing floating rate. As a result, the number of corporates hedging floating rate debt dropped significantly.

When rates suddenly shot up again in response to the post-Covid inflation spike, interest rate hedging was a distant memory in many companies, and often there was no one left who had transacted an interest rate hedge.

This article gives a quick rundown of the main alternatives available when hedging simple interest rate exposure.

Fixed versus floating

Every floating-rate facility is an unhedged position in short-term rates. If rates rise, so do your interest payments, if they fall, you pay less.

Fixed-rate debt has the opposite exposure, if rates fall, you keep paying at the higher rate, and if you want out early, while rates are lower, you pay a break cost reflecting the difference between the fixed rate and the lower rate for all future payments.

The right mix depends on the business. Your capacity to absorb potentially higher rates, and also your need for flexibility (i.e. might you need to break a fixed rate loan early).

A company whose revenues rise with inflation and rates, such as a regulated utility with an indexed tariff, can tolerate more floating rate exposure. A company with fixed-price contracts and thin margins cannot.

Most corporate policies land on a range, say 40-70% fixed vs floating. This can be achieved by selecting the appropriate type of debt, or by adding hedging trades to convert floating exposure into fixed or vice-versa. But the choice should be deliberate.

The forward curve

Before we talk instruments, let's talk pricing.

The rate you pay on your floating rate loan at your next payment date will be set based off the prevailing interest rate at an agreed fixing date, usually within a couple of days or months of that date. Everything else, from the rate on a fixed rate loan, the fixed rate on a swap, and Cap and Floor prices, is determined by where rates are expected to be in the future.

If rates are expected to fall over the period you are hedging, you should be able to lock in a fixed rate below the current prevailing interest rate.

If rates are expected to rise over the period you are hedging, your fixed rate will be above the prevailing interest rate.

We will explore each of the products through both environments:

• A: a hedge placed in June 2014, when rates were expected to rise (they didn't)
• B: a hedge placed in June 2024, when rates were expected to fall (they did, but are rising again).

The instruments

Other instruments

There are a wide range of other hedging instruments but they have more specific uses. We explore them in more detail in the hedging section.

Hedge ratios: how much, for how long

The hedge ratio is the proportion of floating exposure converted to fixed, and it has two dimensions:

• Amount. What portion of your floating rate debt is converted to fixed rates, and
• Tenor. How far into the future have you hedged your floating payments into fixed payments.

Hedging 100% of a five-year loan for five years gives certainty, but it also means you pay the maximum break-cost risk if the loan is prepaid while rates are lower. Hedging 50% for three years gives half the certainty for a couple of years but hedges less than 1/3 of the total risk, and can leave you in a difficult hedging decision when the initial hedge runs out. The decision depends on the company.

In Private Equity, where investment life-span could be 3-7 years, financed by expensive debt which is expected to be repaid or refinanced long before the maturity date, a lower hedge ratio (and flexible hedging products) are the common approach.

For other corporates, many policies step the ratio down over time. High cover initially, lower cover further out where the debt itself may not exist.

Bigger companies often manage the hedging as an overlay independent of any individual loan or maturity.

The practical question is what the hedge is protecting.

• If it is the covenants, the ratio should be set so that the stressed rate scenario still passes interest cover with headroom.
• If it is the budget, it should cover the budget year.
• If it is the lender's requirement (many term-loan agreements require hedging of 50-75% for the first two or three years), it is a condition rather than a choice. In these cases, it is often met in the cheapest or most flexible way possible (low cost, out of the money caps).

Hedge accounting

Under IFRS 9, a swap is a derivative measured at fair value through profit or loss. Without hedge accounting, a swap that is doing its job perfectly still moves the P&L every quarter as the curve moves, which is exactly the volatility the hedge was meant to remove. Cash flow hedge accounting lets the effective part of the fair value movement sit in reserves until the hedged interest is paid. The price is documentation at inception, a demonstrated economic relationship between the swap and the loan, and ongoing effectiveness assessment.

Where it can go wrong:

• Hedging a loan with a swap whose dates, notional or reference rate do not match, so that the mismatch fails the effectiveness test.
• Prepaying the loan and leaving the swap, which ends hedge accounting and dumps the reserve into P&L.
• Hedging forecast debt that is later not drawn.

Scenario analysis

Scenario analysis involves looking at a range of potential interest rate scenarios looking at movements in the current rate, and also the forward curve to assess the impact on your interest payments, the value of your hedges, potential break cost and covenant headroom.

Typical scenarios would look at 100 and 200 basis point moves across the curve, or a return to the historic lows of ultra accommodative monetary policy.

Hedj's own scenario analysis tool allows you to stress your interest rate exposure and the value and break cost of any hedges against any hypothetical rate move or forward curve shape.

Break costs and falling forward curves

People often make the mistake of assuming that large break costs only occur if rates and forward curves move down dramatically after you trade.

Take the example above, a 5-year swap entered into when rates were expected to fall. Even if rates develop exactly as the forward curve dictates (a rare occurrence), in the first 1-2 years in this scenario the fixed rate payer will enjoy positive payments on their hedge, as the prevailing rate is higher than the hedge rate.

However, once this value is extracted from the hedge the final 3 years settle with the prevailing market rate below the fixed rate, obliging the fixed rate payer to pay the difference.

Any request to unwind the hedge once the early payments have been received will result in a break cost.

Basis risk

Basis risk is the gap between how the floating payments on a loan and the same payments on a swap are calculated. The gap usually occurs as a result of mismatched floating rates.

• A loan priced off three-month EURIBOR hedged with a swap on six-month EURIBOR.
• An €STR loan with a EURIBOR hedge.
• A loan with a zero floor on the base rate hedged with a swap that has none.
• A sovereign bond with a EURIBOR hedge.
• For years bank “tracker” mortgages referenced the ECB Main Refinancing rate. Their funding cost didn't, and interest rate hedging mostly referenced EURIBOR.

Every hedge should be checked against the reference rate, the reset dates and the floors in the loan agreement.

The same job at three sizes