Hedge Now, “Pay” Later: Benefits of an Interest Rate Cap

As short-term interest rates continue to hover near zero, intermediate-term swap rates have recently fallen to their lowest levels of 2011, and are approaching all-time lows set in November of last year. For liability-sensitive banks looking to protect their net interest margins from future short-term rate increases, these market conditions provide both a fantastic opportunity and a challenging dilemma:


“I can pay-fixed in a swap today and lock-in a portion of my funding at some of the lowest absolute rates ever seen…”


BUT


“If I lock-in my funding today, and the FOMC keeps the Fed Funds target near zero for years as opposed to months, the relative cost of my fixed-rate funding could be exorbitant…”


Many banks facing this dilemma have taken the path of least resistance: “Do nothing”. Following this strategy has paid off handsomely over the past 30 months, as the fading liquidity shock has allowed FHLB and money-market borrowing rates to converge toward the Fed’s ultra-low Fed Funds target. But continuing on this path today becomes increasingly risky, as the eve of an eventual Fed tightening cycle draws nearer and nearer.


One way to take advantage of low swap rates in the midst of significant market uncertainty is to consider purchasing an interest rate cap. Because caps involve an upfront outlay of cash (cap premium) they are often dismissed as “too expensive” by hedgers. However, even though the cap premium is paid in cash at the inception of the transaction, the recognition of the cap premium expense occurs primarily in the out-years of the contract if a cash flow hedging relationship can be established under the accounting rules. When compared to a swap or fixed-rate funding, a cap provides the hedger with the ability to benefit if rates stay low in addition to providing an upper limit on the hedger’s funding costs. This ability to “have one’s cake and eat it too” is offset by the premium expense, which does not exist with a swap…CONTINUED

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