Geistesblitz 09/19
Geistesblitz / Publications
24. September 2019

Geistesblitz 09/19

Forward-Swap with flexible notional: “Flexi-Swap”

Initial situation

In the current interest rate environment, the demand for interest rate hedges for longer-term financings remains high. On the other hand, short to medium term interest rate hedges 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 in these instances.

The main arguments put forward against interest rate hedging in the current environment are mostly a) the costs involved and b) the limited flexibility. In terms of costs, the last few months have provided further relief regarding the absolute level of interest rates. However, the interest spread of the swap rate over the Euribor or the cap premium to be paid become particularly relevant when the second argument regarding flexibility is given high importance.

In the case of a planned investment project, if there is still uncertainty about the amount of debt capital to be variably financed, it will be difficult to convince the client to hedge its interest rate risk at an early stage, even if interest rates are favourable. In these cases, an ideal solution would be a strategy in which the level of protection is already determined today, but the volume remains adjustable over time.

With the “Forward-Swap with flexible notional” or “Flexi-Swap”, the current Geistesblitz represents an attractive opportunity for companies to reduce their interest rate risk of a rising 3-month Euribor starting in one year for five years. With this strategy the client does not lose his full flexibility today.

Market Overview (September 20th 2019):

3-month Euribor: -0,3930% p.a.
5-year Swap (client’s rate): -0,3300% p.a.
5-year Swap (Start in 1 year): -0,3000% p.a.

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

 

 

 

 

 

 

 

Forward-Swap with flexible notional: „Flexi-Swap“

Product description:

Your client has a financing requirement starting in one year over the following five years. Today he anticipates the financing requirement to be EUR 5 million. The interest payments will be based on the 3-month Euribor plus financing margin.

On the one hand, your client wishes to take advantage of the very low interest rate level by concluding a fixed-rate swap fixing the interest rate for the given period today. On the other hand, there is high uncertainty whether he is going to call the funds as planned and to what extent he will repay the borrowed funds in the future. Yet, the client expects the actual utilisation to be between 50% and 100% of the notional (or EUR 2.5 to 5.0 million).

For the hedge, the client does not want to pay a premium. However, he is prepared to pay a fixed rate above the alternative swap rate in favour of the required combination of security and flexibility. These objectives are reflected in the “Flexi-Swap”.

Indicative terms and conditions:

Notional:                                  5,0 Mio. EUR

Maturity:                                  5 years, starting in one year

Payments:                               quarterly, act/360

Client receives:                       3-month Euribor

Client pays:                              0,00% p.a.

Notional adjustment.:            With each interest period the client has the right to reduce the notional amount to at least EUR 2.5 million.

 

 

 

 

 

 

 

Benefits and risks from a client perspective:

Benefits:

  • Your client locks in a fixed interest rate of 0.00% p.a. (plus financing margin) for his 5-year, variable financing requirement starting in one year.
    At the beginning of each interest period your client is able to adjust the notional flexibly in a range between 50% and 100% (respectively 2.5 to 5.0 Mio. EUR).
  • If the 3-month Euribor undercuts 0.00%, your client has the possibility to tactically utilize the notional adjustments. In the amount of the unhedged position he can participate in negative interest rate fixings.
  • Your customer does not have to pay a premium for this flexibility; it is already included in the interest rate of 0.00% p.a.

Risks:

  • The fixed rate of 0.00% p.a. is above the alternative 5-year rate (-0.33% p.a.) as well as the alternative 5-year forward rate (-0.30% p.a.).
  • Your client cannot participate in negative interest rate fixings of the 3-month Euribor with at least 50% of the notional.

 

In a nutshell

The new Geistesblitz “Forward-Swap with flexible Notional“ or „Flexi-Swap“ shows your client the historically attractive opportunity to utilize a forward hedge at 0.00% p.a. without having to accept a full loss of flexibility. Depending on the actual extent of your clients future financing requirements, your client can reduce the notional of the current interest period by up to 50%. No premium has to be paid for this flexibility.

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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