20. February 2019
In the current interest rate environment, the demand for interest rate hedges for longer-term financings remains very high. Short to medium-term interest rate hedges, on the other hand, are relatively rare. Many variably financed companies do not use supplementary hedging instruments such as interest rate swaps, interest rate caps or tailor-made solutions.
The main arguments put forward against interest rate hedging in the current environment are mostly a) the costs involved and b) the limited flexibility. With regard to the costs (e.g. the swap rate which is higher than the money market rate or the premium of the interest cap), it is also criticised that these arise irrespective of whether the interest rate hedge subsequently brings benefits. In terms of flexibility, an interest rate hedge would generate special benefits if it was only activated when the interest rate level (e.g. the swap rate for the remaining maturity) reaches a previously defined level.
With the “interest cap with contingent premium”, the current Geistesblitz represents an attractive opportunity for companies to reduce their interest rate risk of a rising 3-month Euribor without having to accept additional costs today.
Market Overview (February 15th 2019):
|3-month Euribor||-0.3090% p.a.|
|5-year Swap||0.1600% p.a.|
|5-year Swap (with 0%-Floor)||0.4100% p.a.|
The following chart shows the performance of the 3-month Euribor and the 5-year swap rate over the last 5 years.
Interest cap with contingent premium
Your customer has a financing requirement of EUR 5 million for the next 5 years. The interest payments are based on the 3-month Euribor. He wishes to take advantage of the still very low interest rate level and remain financed on a variable basis. In the medium term, your customer expects low capital market interest rates and assumes that they will not rise significantly until there is an imminent increase in ECB key interest rates.
In the initial situation, we continue to assume that the customer, either based on his own risk assessment or on the initiative of the financing bank, wishes to set an upper interest rate limit if the swap rate for the remaining maturity increased significantly and reached (or exceeded) a previously defined level.
For the hedge, the customer is prepared to pay an annualised premium. However, the premium should be avoided, especially if interest rates remain low. In an environment of rising interest rates, on the other hand, an increase in the interest burden is acceptable for him. These objectives are reflected in the “interest cap with contingent premium”.
Indicative terms and conditions
|Maturity||5 years from spot|
|Cap on 3-month Euribor||1.00% p.a.|
|Contingent premium||0.00% p.a., if reference rate below 0.80%, otherwise 1.00% p.a.|
|Reference rate year 1||5-year CMS-Satz i.a.*|
|Reference rate year 2||4-year CMS-Satz i.a.*|
|Reference rate year 3||3-year CMS-Satz i.a.*|
|Reference rate year 4||2-year CMS-Satz i.a.*|
|Reference rate year 5||1-year CMS-Satz i.a.*|
*: The reference rates are fixed at the end of each quarterly interest period (“i.a.” = „in arrears“)
Benefits and risks from a customer perspective
In a nutshell
The new Geistesblitz “interest cap with contingent premium” offers your customers the possibility of hedging against a significant rise in the 3-month Euribor. This is achieved by an interest cap that bears no premium in a restrained interest rate development. Whether based on their own risk assessment or on the initiative of the financing bank, an upper interest rate limit can thus be set, which remains free of charge depending on the interest rate development. Only if interest rates rise significantly – if the swap rate for the remaining maturity exceeds the predefined level – does a premium become due.
Jan-Henning Becker is Senior Manager at LPA’s Distribution Advisory team. He has more than 10 years of experience in capital markets, having worked at a German investment bank before joining LPA. He is CFA charterholder and has earned the FRM certificate. At LPA, Jan-Henning focuses on consulting topics related to trading and sales of risk management products.