Hedge Interest Rate Risks Swaps & Caps Cost Effectively
How to hedge interest rate risk
The interest on your business loan has two components; a Loan Margin agreed at the outset, plus a variable rate of interest that reprices periodically. Interest rate risk arises from changes in the variable rate (often Base Rate, LIBOR, SONIA or EURIBOR). Interest rate hedging products like an interest rate cap and interest rate swap (swap rate) can be used to protect you against rising variable rates. In this article we will attempt to help you understand how to optimise your interest rate risk management.
Rate Risks for your Business
An increase in the variable interest rate cost (SONIA, LIBOR or EURIBOR) can significantly affect the financial health of your business. It can negatively impact the income statement and cash flow of the business. Hedging is like a form of insurance, providing less uncertainty over future cashflows and profitability. Rates are anticipated to rise further in the EU and UK in 2022. Have you conducted cashflow forecasts and debt covenant analysis of what a 1% rise in interest rates means for your business? Have you considered hedging interest rate risk with swaps or a cap? Hedging benefits:
Better manage the interest covenant ratios/debt service coverage ratios specified in your facility agreement: A rising rate environment could see businesses with variable rates struggle, resulting in their covenants coming under pressure or worse, breached. Our models can tell you the impacts the recent rate hikes will have on cashflows and profitability.
Improved financial performance: Control volatility and risk, protecting your business from unexpected changes in rates
Increase efficiency: Your business will benefit from an end to end solution that integrates risk analysis with cost savings
VUCA enables you to identify and assess the efficiency of you interest rate strategy. This includes:
- – Identifying the true value at risk from Interest Rate exposures
- – Assess historic transaction costs
- – Sensitivity analysis to market volatility
- – Simulated hedge analysis to access the effectiveness of prior strategies
– MIFID, EMIR, FATCA, ISDA, Long Form Confirmation etc
- – Develop Strategy (model cashflows against covenants, balance risk V cost)
- – Get indicative prices from market
- – Select provider(s) based on price, rating and/or other factors
- – Review Facility agreement for Hedge clauses
- – Commercial view on Long form Confirmation or ISDA
- – Confirm with Cap Provider and Borrower that all parties are ready to trade
- – Circulate Term Sheet and indicative price on morning of trade
- – Manage trade call so that purchase is managed professionally
- and price agreed is benchmarked
- – Receive transaction summary from provider
- – Review Confirmation for Key Terms
- – Co-ordinate the payment if necessary
Interest Rate Hedge Example
Managing the risk associated with variable interest rate (SONIA, LIBOR or EURIBOR) expenses on debt can be an irregular exercise for some treasurers. This can make the task seem expensive and complex. VUCA Treasury is in the market daily, we partner with our clients to help level the playing field when negotiating with the bank.
The hedging material provided by banks can be significant in size and appear daunting with the varies products along with their pros/cons. VUCA helps guide companies through this process, conducting stress test analysis to identify the upper limit on your rate exposure and building the optimal hedging solution on the back of this. We stay independent throughout the process meaning we are on your side, making sure the banks stay honest in their pricing.
We have inserted a timeline below of how long a typical hedge will take to implement. Delaying getting your documents back to the financial institute can hold up the KYC process by days.
Interest Rate Hedge Timeline for SONIA, LIBOR & EURIBOR
How do banks hedge interest rate risk? As an independent and unbiased treasury consultancy, Vuca’s mission is to ensure that our clients make informed decisions. As practitioners with multi-decade experience in the financial and capital market divisions of major global banks, we have the inside track on how banks structure and price derivatives. We leverage this insight to ensure that our clients get the most competitive terms when they look to buy an Interest Rate Cap. For an optimum result you should contact us as early on in the process as possible, preferably before you speak with your bank