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Interest Rate Caps: Why they are often better than Swaps: Caps should always be seriously considered when hedging variable interest rate risk. For the last twenty years, borrowers who have hedged using caps experienced much lower interest rate costs than those using swaps, yet swaps are still more popular. This white paper discusses the market forces behind this strange phenomenon: swaps are more profitable for banks, and borrowers hate up-front fees.
Hedging with LIBOR Floors: Caps are better than Swaps: During the current low interest rate environment, LIBOR floors have been required by lenders in variable rate loans to boost their returns. Such loans can be hedged using either interest rate swaps or caps. This white paper analyzes the benefits of choosing a cap over a swap, even though caps require up-front payments. The benefits include (1) flexibility on termination, (2) lower interest costs and (3) a possible return on the sale of the cap.
Choosing a Swap Rate: Swaps vs. the “True” Cost of LIBOR: When deciding on whether to lock-in a fixed rate with a swap, borrowers often compare the swap rate to current or historical LIBOR rates. This white paper argues that the proper comparison is made by using the “true” cost of LIBOR…a multi-year historical average of LIBOR over a term as the swap. This approach guards against locking-in a fixed rate at a time of a short-term elevation in LIBOR.
Calculating a Swap’s Termination or Market Value: As interest rates rise and fall, so does a swap’s market value. The main drivers of a swap’s value are (1) the current swap market rate and, (2) the swap’s remaining maturity. This white paper describes a simple formula to approximate a swap’s value with a minimum of inputs and calculations.
How Swap Rates are Calculated, and Banks make a Profit: Banks set swap rates for their customers by acting as a middleman between the borrower and the wholesale swap market. In order to ‘lock in’ a profit margin for itself, the bank hedges the transaction by entering into an offsetting swap, simultaneous to the swap executed with the borrower. Fluctuations in LIBOR over time are hedged over time, while the bank’s profit comes from the difference between the rate the bank receives from the customer and the fixed rate it pays to the market.
Loan Hedging Requirements: How to Best Deal with Them: Often a bank will include a “hedging requirement” in a variable LIBOR rate-based loan offer, mandating that the borrower enter into an interest rate swap upon closing the loan. It is important to understand the motivation and incentives of the bank regarding such a hedging requirement for a loan. This paper will “pull back the curtain” on such a requirement and discuss a borrower’s best approach to satisfying/negotiating such a requirement.