Is it time to hedge interest rate risk?

Although this forward-starting swap requires no upfront cash payment, it’s disingenuous to suggest that it is costless. Certainly, there is an opportunity cost. That is, this contract locks in a rate of 0.4420 percent, such that if market interest rates were lower, the hedging entity would be forced to forego the benefit of these more attractive market rates. Furthermore, we should recognize that this swap requires “paying up” from the current LIBOR of 0.24295 percent, in order to fix our cost of funds. Thus, we can quantify the present value of the incremental difference between paying this 0.4420 percent versus starting LIBOR of 0.24295 percent. We calculate this cost for each accrual period using the equation shown at the top of the accompanying table (corresponding to each row), and we then sum these results to get the aggregate “pay-up” cost.

For illustrative purposes, we perform this exercise assuming a 12-month swap having a start date of January 1, 2015 and a notional size of $10 million. Reset rates shown in the table reflect the forward rate structure as of the trade date (February 7, 2014). The resulting pay-up cost of $20,270, or, equivalently, 0.2027 percent of the notional amount of the swap. If we’re ready to pay-up that much for a swap, what would a cap look like that costs that same amount of money? We should realize that we can construct a cap for any budget. A more expensive cap will protect from a lower threshold interest rate (i.e., a lower strike rate), while a cheaper cap would protect from a higher threshold (i.e., a higher strike rate). The question is this: If the cost of the cap were set equal to 0.2027 percent of the notional amount, what strike price would that cap have? In this case, the answer is 0.4894 percent. That is, for a premium payment of $20,270, the hedger could assure that the cost of funds in every month will not to exceed 0.4894 percent (exclusive of the credit spread). In some months we may be constrained by this maximum, but in other months we may be able to enjoy the benefit of cheaper funding. In contrast, the swap’s resulting fixed rate applies uniformly for all the months during the horizon being hedged.

This article was initially published in the July/August issue of the Association for Financial Professionals' AFP Exhange Magazine

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