Geistesblitz 03/19
Geistesblitz / Publications
25. March 2019

Geistesblitz 03/19

USD interest hedge with “CombiSwap”

Initial Situation

Storm clouds are brewing on the horizon of the US economy as well.  The country appears to be in the final stage of the economic cycle. Thus, for short and medium term maturities the yield curve is partially inversed. Since mid-December, the difference between the 5-year swap rate and the 3-month USD Libor has been negative.

As a result, interest rate hedges for corporates with USD interest rate exposure have recently moved back into focus. In the current interest rate environment, it is more advantageous to hedge a variable financing at the lower swap rate from a short term perspective. The question of whether it is also the right timing for an USD interest rate hedge is answered by corporates – as is usually the case – very individually.

The Geistesblitz presents the “CombiSwap” (aka “CapSwap”); an attractive way for companies to limit their interest rate risk of a rising 3-month USD Libor for 5 years. In return, they neither have to forego participation in low 3-month USD Libor rates for the next fixing periods, nor do they have to accept a fixed rate higher than the 5-year swap rate.

Market Overview (March 22nd 2019):

3-month USD Libor: 2.6098% p.a.
5-year CMS rate: 2.2630% p.a.
alternat. 5-year Swap: 2.3500% p.a.
alternat. 3.5-year Swap: 2.2800% p.a. (start: 28.09.2020)

The following chart shows the performance of the 3-month USD Libor and the 5-year swap rate over the last 5 years.

USD interest hedge with “CombiSwap”

Product description

Your client has a financing requirement of USD 5 million for the next 5 years. He pays an interest rate based on the 3-month Libor. In the medium term, your client expects higher money and capital market interest rates and prefers a fixed rate. He is therefore considering a hedge using a 5-year swap at the current rate of 2.35% per annum. However, in view of the uncertainty of the short-term development of the 3-month USD Libor – in particular the possibility of a significant drop in the 3-month USD Libor – he would like to remain financed on a variable basis for the time being, and hedging only a maximum interest rate. However, he is not prepared to pay a premium for this hedge.

For the next 6 interest periods (1.5 years) your client will purchase a cap 2.79% p.a. on the 3-month USD Libor. For the following 14 interest periods (3.5 years) he hedges a fixed rate of 2.35% p.a., hence at the level of the alternative 5-year swap rate. These objectives are reflected in the “CombiSwap”.

Indicative terms and conditions

Maturity 5 years from spot
Payments quarterly, act/360
Client receives 3-month USD Libor
Client pays:
Period 1 to 6 (Cap) 3-month USD Libor, max. 2.79% p.a.
Period 7 to 20 (Swap) 2.35% p.a. (fixed rate)

Benefits and risks from the clients perspective

Benefits

  • Your client locks-in an upper interest rate limit for his variable
    financing, initially in the form of a Cap at 2.79% p.a., followed by a fixed rate of 2.35% p.a.
  • During the Cap phase (up to and including interest period 6),
    your client continues to participate in low USD interest rates.
  • Your client pays neither a Cap premium for the Cap phase, nor a higher interest than the alternative 5-year swap rate in the subsequent Swap phase.

Risks

  • The upper interest rate limit on the 3-month USD Libor is 0.44% p.a. above the alternative swap rate. Based on current market data (latest fixing), your client would pay approx. 2.61% p.a.
  • At the start of the Swap phase (from interest period 7), your client can no longer participate in lower USD interest rates.
  • Although the fixed rate of the Swap phase does not exceed the alternative 5-year swap rate, it does exceed the rate of a 3.5-year forward swap (starting in September 2020) at 2.28% p.a. (the relevant benchmark).

In a nutshell

The new Geistesblitz  with the “CombiSwap” presents a possibility for your client to hedge his variable interest payments.  A  short term hedge using a  Cap is followed subsequently by Swap. Your client initially continues to participate in possibly decreasing 3-month USD Libor rates. However, he neither has to pay a premium, nor does he has to accept a fixed rate higher than the 5-year swap rate.

 

About the author
Jan-Henning Becker

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.

Jan-Henning Becker
Senior Manager

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Jan-Henning Becker
Senior Manager

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Jan-Henning Becker
Senior Manager
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