Designing a Suitable Hedge Program
A client had just replaced their syndicated bank loan with a new loan having a lower LIBOR rate. The client had executed a swap on their previous loan, which was still outstanding. Unlike the loan it replaced, the new loan had a minimum LIBOR rate (floor), which made the client’s current swap potentially ineligible for hedge accounting.
DAG reviewed the original swap hedge documentation, and we determined that the swap would have to be terminated. The client initially wanted to replace the swap with another swap; and since the loan had a LIBOR floor, the new swap would also have a built-in LIBOR floor to match (in order to achieve hedge accounting).
DAG discussed with the client whether a swap would be the best structure for their needs, taking into account their risk preferences and the current market environment. DAG then analyzed various hedge structures as alternatives to the “floored” swap.
DAG calculated the present value of these different hedges under various future LIBOR rate scenarios, comparing them to the swap. Based on the client’s outlook on rates, and because of the significant cost of the built-in floor in the swap, DAG calculated that there would be a significant savings if the client were to utilize a cap structure instead of a floored-swap.