Hedging floating rate term-loan with an interest rate swap

Scenario analysis

Important note: This simulation uses fictitious data for illustrative purposes only.

For personalized advice, please consult your bank or trusted treasury advisory partner.

What is an interest rate swap?

An interest rate swap offers a cost-effective solution for managing interest rate risk exposure in mid-market companies such as commercial real-estate, manufacturing, social housing etc.

Interest rate swap:

offers a easy way to safeguard your floating rate borrowings from rising interest rates. By locking in a fixed rate, you can achieve greater financial stability and predictability of your interest rate cash-flows.
enables mid-market treasurer to fine-tune the interest rate risk exposure of the overall debt portfolio. By allocating a portion of the debt to a traditional interest rate swap (pay fix, receive floating) and leaving the remaining portion of the debt portfolio un-hedged, companies can also strike a balance between hedging obligations and flexibility.

Important note: ask your bank or treasury advisory partner for accredited product advise

Using interest rate swaps

Why?

Interest rate swap safeguards borrowers with floating rate loans from potential increases in short-term interest rates.

How?

A common swap structure in finance is a pay-fixed swap, where the borrower pays a periodic fixed-rate receives floating rate index in return.

A pay-fixed swap is a financial instrument designed to transform a floating-rate liability into a fixed-rate liability.

1. Neutralizing Variable Rate Exposure

The borrower pays a predetermined fixed interest rate and receives a variable (floating) interest rate payments in return.
This stabilizes loan payments by offsetting variability in floating-rate liabilities.

2. Reset Date Scenarios

When the floating rate exceeds the fixed rate:
The borrower receives the difference, reducing the overall interest rate cost to the level of the agreed fixed rate.
When the floating rate falls below the fixed rate:
The borrower pays the fixed rate while receiving the floating rate on the swapped portion.

3. Outcome

Interest rate swap ensures that the borrower’s total cost of funds does not exceed the budgeted fixed rate level, offering stability against fluctuating interest rates.

Example: Hedging a floating rate loan with an interest rate swap

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Advantages of the Interest Rate Swap

Interest Rate Certainty

The borrower enjoys peace of mind by knowing the maximum interest rate of the loan.

No Initial Investment

attractive option for borrowers seeking to hedge their interest rate risk without additional upfront costs.

Separating Financing and hedging decisions

Separating financing and hedging strategies offers greater flexibility, especially in managing prepayment risks.

Pre-hedging future financing projects

Lock in favourable interest rates at the start of your investment project with a forward-starting interest rate swap.

Disadvantages of the Interest Rate Swap

Fixed Rate>Floating rate

The swap rate associated with this product is typically higher than the floating rate.

Limited flexibility

If floating interest rates remain below the swap rate throughout the term of the hedge, the borrower may not realize significant benefits from the hedge.

Market Value changes

The value of the swap can change over time, depending on interest rate movements. This can impact the borrower’s financial position and earnings.

Potential Termination Costs

Early termination of the hedge, especially in a low-interest-rate environment, could result in substantial termination costs on the swapped portion of the debt.

Main differences:
Hedging a floating rate loan with an participating interest rate swap vs. interest rate swap

Main differences of the participating interest rate swap compared to the interest rate swap are:

Higher hedge rate (fixed rate) than with traditional interest rate swap
Some degree of participation in case of declining floating rates
Termination cost could be higher than with traditional interest rate swaps
Not very often used for forward starting financing projects

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