Interest Rate Swap or Interest Rate Cap?

Interest rate swaps and interest rate caps can be effective hedge tools to minimize interest rate risk.  However, in order to use these tools effectively, a borrower needs trustworthy advice to select the right hedge tool and to negotiate attractive terms and competitive pricing.  As an independent advisor, DerivGroup puts your interests first.  DerivGroup understands your hedging objectives holistically, and recommends an optimal hedge structure with the most favorable terms and pricing.

What Is an Interest Rate Swap?
A standard interest rate swap is a contract between a borrower and a lender.  The agreement sets out the terms for exchanging an existing variable rate loan structure with a fixed rate structure, or for exchanging a fixed rate loan structure with a variable rate structure.  Variable rate loans and fixed rate loans have inherent advantages and disadvantages, depending on the current state and future outlook of the interest rate market.

DerivGroup helps you determine whether an interest rate swap is a necessary component your overall hedging program.  If so, DerivGroup helps you select the right interest rate swap based on your needs and objectives.  Then DerivGroup sits on your side of the negotiating table, helping you win the best pricing and terms from your bank, or finding you a better deal elsewhere.  In fact, DerivGroup supports you throughout the negotiation and execution process, and can also provide hedge accounting during the life of the interest rate swap.

For in-depth analysis of Interest Rate Swaps, please see the following DerivGroup white papers:

• “Choosing a Swap Rate: Swaps vs. the ‘True’ Cost of LIBOR”
• “Calculating a Swap’s Termination or Market Value”
• “How Swap Rate are Calculated, and Banks Make a Profit”
• “Loan Hedging Requirements: How to Best Deal with Them”

What Is an Interest Rate Cap?
An interest rate cap is a variable rate loan structure that enables a borrower to negotiate a pre-determined cap on the variable interest rate.  If future interest rates exceed the cap, the borrower does not pay interest charges higher than the pre-determined cap.

Although the borrower does pay an additional up-front premium, a properly structured interest rate cap often benefits the borrower over the term of the loan.  With an interest rate cap, the borrower effectively locks in a maximum rate, while retaining the opportunity for reduced interest expense if rates remain low or go even lower.

DerivGroup advisors analyze the economic environment and the interest rate markets to determine the optimal hedge to fit your needs. In the process, DerivGroup helps you consider the potential advantages of using an interest rate cap.  In many cases, an interest rate cap can be a more cost-effective tool than an interest rate swap to accomplish a hedging objective.  Because interest rate caps tend to have lower profit margins (for the lender) than interest rate swaps, banks often push their clients toward an interest rate swap.  As a result, interest rate caps can be purchased at a better price from a third-party bank.

For in-depth analysis of Interest Rate Caps, please see the following DerivGroup white papers:

• “Interest Rate Caps: Why They are Often Better Than Swaps”
• “Hedging Loans with LIBOR Floors: Caps Are Better Than Swaps”

Interest Rate Swaps and Interest Rate Caps—Properly Structured—Save Hundreds of Thousands in Interest Expense

The example below illustrates one of many success stories in helping clients effectively manage interest rate risk using interest rate swaps and interest rate caps.  In this example, DerivGroup’s client was refinancing an $8,000,000 bank loan on a commercial property.  Upon consulting with DerivGroup, the client decided on a partial interest rate cap/swap structure for the new bank loan.  DerivGroup was able to source the interest rate cap component of the hedge for a lower cost than the client’s bank would sell it.  DerivGroup was also successful in negotiating a lower rate on the interest rate swap component of the hedge.