Similar to home or car insurance, Interest Rate Caps provide protection for borrowers against loss in return for the payment of a premium. The good news for borrowers is that Cap premiums are falling. In this article we explore why borrowers should be paying attention
Two of the primary factors influencing the cost of Cap premiums are:
- The SONIA Forward Curve: the forecast projected path for SONIA taken at a point in time
- Implied Volatility: a measure of how confident the market is that the actual path that SONIA will take will be close to the forward curve
We can see from the chart that Cap pricing for both GBP and EUR loans surged in 2022 as central banks aggressively tightened monetary policy as inflation surged. Forward curve were ratcheting higher, causing implied volatility to spike and steep rises in Cap premiums.
For example, a GBP Cap with a strike set at the prevailing swap rate almost trebled between December 2021 and September 2022 and the cost of a EUR Cap doubled. Since then the macro environment has shifted. Inflation in both the UK and EU fell below the BOE and ECB’s 2% target by Q4 2023 and interest rates were cut from 5.25% to 4.0% in the UK and from 4.0% to 2.0% in the Eurozone. For the past 6-12 months, forward curves have been relatively stable resulting in a sharp decline in implied volatility over the past year. Cap premiums have followed suit and the premium cost of 3-year Caps for both GBP and EUR are now at 4 year lows.
Despite the recent calm in rates markets, the geo-political and economic outlook remains highly uncertain. UK Inflation could hit 4.0% when the latest CPI update is released this week, large budget deficits in the UK and France and other major economies including the US and Japan are raising concerns about fiscal stability and trade tensions between the US and China are resurfacing. In this context, the current pricing of interest rate caps presents a strategic hedging opportunity. Caps offer:
- Downside participation if SONIA or Euribor set at lower levels
- Protection against tail risks, such as a renewed tightening cycle or a repeat of the 2022 rate shock after the Truss/Kwarteng budget
- Flexibility, especially compared to more rigid hedging instruments like Swaps
- No Break cost if the Cap is not held to term (once the premium has been paid)
For borrowers and risk managers with large floating rate debt- or hedges due to mature in the next 6 to 12 months, the drop in the cost of Caps presents a strategic opportunity to reduce cashflow risk in a favourable pricing environment. We saw in 2022 how market sentiment and hedging costs can shift rapidly. Borrowers would be well advised to take advantage of the improved pricing available and ensure that hedging levels are appropriate.
Vuca Treasury is a specialist interest rate and currency hedging advisor. Please feel free to contact the team at hedging@vucatreasury.com if you’d like to review your interest rate risk position
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