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3.5.2 Collar

The Interest Rate Cap cost may be reduced or eliminated by using a Collar, which by contrast enables a kind of uniformity to be imposed on the instalments due. In practice, a Collar is comprised of a combination of a Cap and a Floor (the latter being the exact opposite of a Cap, in that it sets a minimum interest rate rather than a maximum rate), thereby creating a range within which the interest rate may vary. A transaction incorporating a Collar will entail the purchase of a Cap and the sale of a Floor. If the interest rate exceeds the Cap, the difference will be paid by the counterparty, whilst if it falls below the Floor, the difference will be paid to the counterparty. Figure 3.3 shows an example of hedging using Caps and Collars.

3.5.3 Interest Rate Swap

Another form of interest rate hedging may be obtained by procuring an Interest Rate Swap (IRS). Under such contracts the parties undertake to pay or collect at pre-determined dates amounts calculated on the basis of the differences between various interest rates. In practice,

Hedging using Caps and CoEars

FIGURE 3.3 Hedging using Caps and CoEars

a Swap may be regarded as an exchange of interest rate payments between two parties which are seeking hedge against changes in the interest rate.

A Swap involves an exchange of interest payments calculated on a certain agreed reference principal (notional) for a predetermined period of time until the term of the agreement: the borrower will pay a fixed level of interest to the counterparty, whilst the latter will pay a floating rate, and the reference principal under the agreement is at no time exchanged between the contracting parties.

The contracting parties will exchange interest rate payments based on a fixed rate and a floating rate, whereby the fixed rate is due to the seller (usually a bank) and the floating rate is due to the buyer (borrower); the difference between the two rates will establish the amount payable and the party to which it will be due. As long as the floating rate does not exceed the fixed rate agreed upon during the term of the contract, the counterparty bank will have a cash inflow; however, if the floating rate (e.g. EURIBOR) exceeds the fixed rate agreed upon, the counterparty will have a cash outflow which will be used to pay the interest rate on the loan.

In contrast to fixed-rate loan agreements, interest rate Swap agreements are concluded separately with a counterparty which is not necessarily the lending bank; in such cases, the payments (cash outflows for the counterparty and cash inflows for the borrower) must be clearly earmarked for the loan by an express commitment or assignment. Moreover, in some cases, these contracts may be transferred from one loan agreement to another and, in the event that the loan is redeemed, may result in entitlement or liability to payments on the part of the borrower, depending upon the level of the interest rate at the time of redemption.

EXAMPLE 3.1

Given a floating-rate loan with interest tracking the EURIBOR 3 month rate, a 5 year IRS is bought at a fixed rate. The term of the operation extends to 5 periods, following which the variable exchange rate will apply once again.

Under the terms of the agreement entered into prior to drawdown, the borrower will pay to the bank (IRS agreement counterpart) the fixed-rate interest payments (equal to 2.5%) at each maturity date and will receive the floating-rate interest payments, calculated on the basis of the EURIBOR 3 month fixing.

In the example in Figure 3.4, the borrower will use the interest payments received in order to pay interest on the loan where the EURIBOR 3 months exceeds the IRS.

Effects of hedging with a Swap

FIGURE 3.4 Effects of hedging with a Swap

An Interest Rate Swap contract provides for the conclusion of numerous agreements between the seller of the IRS (the bank) and the buyer (the borrower):

• the reference amount on which the interest rate flows exchanged is to be calculated (notional amount);

• the currency in which the reference amount is denominated;

• the fixed rate, also known as the IRS rate, representing the price of the Swap.

The defined level of the interest rate is the principal element of the agreement, and will depend upon numerous factors, such as:

• the term of the agreement;

• the parameter chosen as a reference for the floating rate (generally the 3 or 6 month EURIBOR or the LIBOR for non-Euro transactions) and any other element characterizing the transaction;

• the fixing date on which the floating rate is set;[1]

• the frequency[2] of payments at the fixed or floating rate when interest payments are due (annually, quarterly, or every six months).

A simple example may assist in clarifying the IRS mechanism.

Alongside the simple structure presented, it is possible to use Swap agreements based on the hedging requirements for the specific loan. In particular, an amortizing Swap enables the notional principal to be reduced in line with the term of the loan. For example, the parties may agree for a particular loan that the interest rate difference is calculated on a different notional amount at the end of each period, which is reduced in line with the repayment plan for the loan which it is intended to cover.

A Swap may be combined with a Swaption, an option granting the buyer the right, but not the obligation, to conclude a Swap agreement on a given future date according to terms specified in advance (term and reference rates).

The combination of a Swap and a cancellation option will create a cancellable Swap, which entitles one of the counterparties to cancel the IRS at a certain date without any requirement to pay penalties.

Finally, rather than concluding a hedging agreement or choosing a fixed rate of interest, the parties may incorporate a “Drop Lock” clause into the loan agreement, namely a clause under which the borrower provides the bank with an irrevocable mandate to convert the floating rate into a fixed rate when the IRS reaches a specific agreed threshold.

EXAMPLE 3.2

If the contractual rate tied to the EURIBOR is 1%, the IRS at the time the agreement is concluded is 3%, and an IRS threshold rate of 4% is set (Drop Lock level), when the IRS rate reaches 4% the bank must immediately convert the floating rate into a fixed rate in order to ensure that any further increases do not result in any liability on its part; the IRS threshold of 4% therefore has the goal of protecting the bank if further rate rises are expected. Since they are irreversible, such clauses often give rise to disputes.

  • [1] In general this falls two working days prior to the start of each period.
  • [2] The same maturity dates are often chosen for the two rates.
 
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