Forward hedging FAQ
Movements in short-term rates like SOFR, used as indices for floating-rate financings, present a commonly understood source of interest rate risk for commercial real estate (CRE) borrowers. Movements in longer term interest rates can also create risk for borrowers. This guide examines the sources and nature of these risks, the strategies and products used to mitigate these risks, and the limitations and considerations with implementing them.
- What risks do CRE borrowers address with forward hedging?
- What are the common products for managing these risks?
- What are the key economic provisions for forward hedging products?
- Should I hedge Treasury yields or swap rates?
- Are forward hedges easy to obtain?
- How are the lock products priced?
- How are option products priced?
- How do forward hedges settle?
- Should I structure my forward hedge to match exactly the loan amount I want to hedge?
- Will I need to come out of pocket when I settle my forward hedge?
- Will my forward hedge effectively hedge my all-in loan coupon?
- Will a forward hedge directly impact my loan coupon?
- Will a forward hedge protect against reduced proceeds on a Debt Service Coverage Ratio (DSCR) constrained loan?
- How important is it that the expiry of my forward hedge exactly matches my refinance date?
- Can forward hedges receive favorable U.S. GAAP accounting treatment?
What risks do CRE borrowers address with forward hedging?
Future fixed-rate financings, such as take-out financings of bridge or construction debt, replacements of existing fixed-rate debt, or unsecured bond offerings are susceptible to movements in long-term rates. These financings price at some spread to a market-based rate (typically a Treasury yield or a benchmark swap rate), and increases in base rates flow through to the loan coupon (absent spread compression). In such a situation, the borrower may be hurt by rising rates if spreads don’t compress.
A less common risk is the impact of rate movements on prepayment penalties associated with fixed-rate debt. Most fixed-rate CRE loans have prepayment penalties that are driven by the spread between the coupon on the loan and a market-based rate (often Treasuries) for the remaining term of the loan. If these base rates fall leading up to a prepayment, the prepayment penalty will likely increase. In this situation, the borrower is hurt by falling rates.
What are the common products for managing these risks?
The best approach for managing a future fixed-rate financing is a lender rate lock or other lender forward commitment. These will typically allow a borrower to lock-in an all-in rate for a set amount of proceeds, allowing a borrower to know with certainty the cost of their financing.
Unfortunately, lender rate locks or forward commitments are not available until a loan is under application (or are not available at all) and are not relevant for hedging prepayment penalties. In these situations, borrowers can use derivatives to hedge movements in base rates like Treasury yields or swap rates, with the hedges providing a payout to the borrower if rates move in a way that would negatively impact the coupon on their financing or prepayment penalty. It’s helpful to classify these products in two categories: lock products and option products.
Lock products are hedges which allow a borrower to “lock-in” a specific base rate (like the 10-year Treasury yield or the 10-year swap rate) for a future date. The borrower receives a settlement if rates move in one direction relative to that locked rate but makes a settlement if rates move in the other direction. This settlement doesn’t change the underlying loan coupon or prepayment penalty but is designed to offset them. Rate movements that cause “bad news” on the new loan/prepayment are offset by “good news” on the hedge and vice versa. Lock products typically don’t involve an upfront cost to the borrower but may require they make a large settlement payment. A lock product on a Treasury yield is known as a “T-Lock,” while a lock product on a swap rate is known as “forward starting swap.”
Option products are hedges which allow a borrower to receive a payment if a specific base rate moves past a certain threshold. They typically require the payment of an upfront premium but don’t expose the borrower to the risk of a future settlement. Options on a Treasury are either Treasury “puts” (which pays out if Treasury yields rise) or Treasury “calls” (which pay out if Treasury yields fall). An option on a swap rate may be either a “receiver swaption” (which pays out if rates fall) or a “payer swaption” (which pays out if rates rise).
What are the key economic provisions for forward hedging products?
All forward hedges have four major economic terms:
Notional amount: The size of the hedge, the face amount from which any settlement amount is calculated. It is typically proportional to the size of the underlying exposure being hedged.
Index: The underlying index being hedged, which is typically a benchmark interest rate like a 10-year Treasury.
Strike rate: The threshold rate which is compared to market prevailing rates to determine if there is a settlement and, if so, the size of it.
Exercise date: The date or dates on which the hedge is settled.
|Product||Notional||Index||Strike rate||Exercise date|
|T-lock||$100M||10-year Treasury||1.75%||Three months|
In the example above, if the 10-year Treasury exceeds 1.75% at the end of the three-month period, the borrower would receive a settlement based on the difference between the market Treasury yield and the 1.75% strike rate, proportional to the $100M notional. If the 10-year Treasury is less than 1.75%, the borrower would be required to make a payment based on the difference between the market rate and 1.75%.
The example below is a payer swaption, which pays the borrower if rates rise above a certain threshold. If the 10-year swap rate exceeds 2.50% on the two-year expiry date, the borrower will receive a settlement payment based on the difference between the prevailing market rate and 2.50%. If the 10-year swap rate is less than 2.50%, the option expires worthless, and the borrower receives no payment.
|Payer swaption||$50M||10-year swap rate||2.50%||Two years|
Should I hedge Treasury yields or swap rates?
Several factors influence whether a borrower hedges Treasury yields or swap rates, including:
Nature of the underlying exposure: In some cases, the underlying exposure being hedged may be clearly tied to a specific base rate. A borrower hedging a loan that prices as a spread to the 10-year swap rate will want to hedge the 10-year swap rate. Similarly, a borrower hedging the impact of a decline in rates on a yield maintenance calculation based on Treasury yields would want to hedge Treasuries. In many cases, the hedged exposure may not be tied to a specific rate (at least at the time that the hedge is executed).
Duration of hedge: There is good liquidity for short-dated hedges of both swap rates and Treasury yields. For longer dated hedges, however, liquidity and pricing for Treasury-indexed hedges become less favorable. It’s unusual to hedge Treasury yields for more than six months and very unusual to go out beyond 12 months.
Due to the considerations above, it's more common to see CRE borrowers hedge swap rates.
Are forward hedges easy to obtain?
The choice of a lock or an option product tends to drive much of the availability of forward hedges.
Option products are paid for upfront and never require a future payment from the borrower. This permits the borrower to obtain one from a variety of market maker banks even if they have no other relationship with the bank.
Lock products involve a potential future payment from the borrower to the dealer bank which makes the dealer bank concerned with the borrower’s credit. This means that the borrower will either need to collateralize the hedge (often with independent and variation margin paid in cash) or the borrower will need a dealer bank that is already extending them credit in another form.
In either case, the dealer bank will need to perform typical Know-Your-Customer (KYC) and Anti-Money Laundering (AML) checks on the borrower before providing a hedge. A borrower should anticipate at least one-to-two weeks of lead time between starting this process and being in a position to execute the hedge.
How are the lock products priced?
Lock products (T-locks and forward starting swaps) typically don’t involve an upfront cash cost. A future rate for an underlying market index is locked in and the eventual settlement is calculated based on the difference between the locked rate (strike rate) and the prevailing market rate at the time of settlement. The all-in strike rate is comprised of three components:
Spot rate: This is the current level of the index rate being hedged. This rate will change over time but is objective and observable in the market.
Forward carry: This is an adjustment to the spot rate to reflect the market implied expectations for the index rate on the date of the hedge expiry. Taken together, the spot rate plus the forward carry sum to the forward rate. This is also an objective number and observable in the market.
Credit charge: This is a transaction specific number (expressed in basis points) which is added to the forward rate. It is designed to compensate the hedge provider for their credit risk and to provide them with profit. This is negotiated on a deal-by-deal basis.
How are option products priced?
Option products (T-options and swaptions) typically involve payment by the borrower of a single, upfront premium. Several factors drive the size of this premium:
Notional: The notional is the face amount of the hedge. The size of the hedge premium will increase proportionally with the size of the notional. For example, a $100M swaption will cost around twice the cost of an otherwise identical $50M swaption.
Expiry date: The expiry date of an option is the date on which it is settled. All else equal, an option with a further date expiry will cost more than one with a nearer dated expiry.
Strike rate: The strike rate of an option is the threshold rate beyond which the borrower will start to receive a payment. For instance, a swaption on the 10-year swap rate with a strike of 2% pays the borrower if 10-year rates rise above 2%. All else equal, the premium payment for an option will get larger as the strike rate gets closer to current rates (for example, the 2% strike swaption just mentioned would cost more than a swaption with a 3% strike).
Interest rate expectations: Expectations of future interest rates impact option pricing. If a swaption that is structured to pay out when the 10-year swap rate hits 2% in one year will be more expensive if the market expects this rate to hit 2.25%. The same swaption would price lower if the market expects the 10-year swap rate to hit only 1.75%.
Interest rate volatility: Interest rate volatility measures the market’s expectation of how likely actual future rates are to diverge from current expectations. Higher interest rate volatility suggests a higher likelihood of the dealer bank making a payment to a purchaser of an option that is larger than expected. Greater interest rate volatility will tend to increase the cost of options. This will be most noticeable to borrowers in volatile market conditions — in these environments borrowers can see significant increases in option costs.
How do forward hedges settle?
Forward hedges are typically structured to “cash settle” with one party paying the other a lump sum at the hedge expiry.
This lump sum is based on the differential between the prevailing market rate at the time of settlement and the strike rate on a hedge. This differential is applied to the hedge notional and considers the term of the underlying hedged index so that the borrower arrives at a settlement which is equivalent today to the rate differential over the underlying term.
As an example, assume a borrower has entered into a hedge with a notional of $100M that is designed to pay out if the 10-year swap rate exceeds 2.00%. If the market 10-year swap rate is 2.25% on the day of settlement, the payout amount would be roughly: $100M x (225 bps – 200 bps = 25 bps) x 10 years = $2.5M. This would be further adjusted by a present value (PV) factor as the cash settlement is designed to capture the PV of the 25-basis point difference in rates over the next 10 years. In this case, the PV factor would be 0.93 (which represents the difference between the PV and future value of 25 bps in monthly interest over the next 10 years), implying a settlement of $2.33M. This PV factor is based on the discount curve used by dealer banks, which is typically based on SOFR, not a borrower’s cost of funds.
Should I structure my forward hedge to match exactly the loan amount I want to hedge?
Most often, no. Per the description above, hedge settlement is a cash payment based on the PV impact of a rate differential over the life of a loan, discounted using a dealer bank’s cost of funds. In practice, this means that the required hedge notional is often less than the loan amount hedged, for the following reasons:
- Borrower discount rate: A borrower’s cost of funds is typically higher than the bank discount factor used for calculating a hedge settlement. The higher the borrower’s cost of capital, the smaller the lump sum settlement needed to offset higher future interest expense, and thus the smaller the hedge notional required.
- Loan amortization: The cumulative impact of higher interest rates is smaller for loans with principal amortization than with interest only loans. Loans with more rapid amortization need smaller hedges.
- Prepayment assumptions: The impact of a higher loan coupon is more pronounced on loans held to maturity relative to loans prepaid early. A borrower expecting an earlier loan prepayment will want to reduce the size of his hedge.
The ratio of the hedge notional to the loan principal hedged is commonly called the “hedge ratio.” Hedge ratio calculation should be done on a transaction-by-transaction basis but is often between 80%–95% of the loan amount being hedged.
Will I need to come out of pocket when I settle my forward hedge?
Depending on the product, yes. Option products are structured so that a borrower will never come out of pocket when a hedge settles (though they will pay a premium at the inception of the hedge). Lock products can settle with the borrower required to make a payment to the hedge provider if rates move in the opposite direction of the movement being hedged. This settlement payment can become quite large and is one of the reasons many CRE borrowers prefer not to use lock products.
Will my forward hedge effectively hedge my all-in loan coupon?
Lender rate locks are the only hedge products that effectively hedge an all-in loan coupon. Other products can hedge market benchmark rates like Treasury yields or swap rates but do not hedge individual loan coupons. This is a key limitation of forward hedging and can result in unintended outcomes in some market conditions where a hedge does not pay out to a borrower (because base rates have not risen) but the borrower still has a higher loan coupon (because credit spreads and all-in rates have risen).
Will a forward hedge directly impact my loan coupon?
Only lender rate locks will allow an actual lock of a loan coupon. Other hedges of base rates (Treasury yields and swap rates) are designed to provide lump sum cash settlements that offset higher rates on a new loan. The actual loan coupon is unaffected by the hedge, but the borrower receives cash which, when amortized over the life of the loan, is designed to reduce the effective interest expense.
Will a forward hedge protect against reduced proceeds on a Debt Service Coverage Ratio (DSCR) constrained loan?
Lender rate locks may serve this purpose, but hedges of base rates will not. Base rate hedges are typically structured to only provide an offset to higher interest expense, not compensate a borrower for lost proceeds from higher rates.
How important is it that the expiry of my forward hedge exactly matches my refinance date?
Borrowers typically want to match the expiry of their hedge to an expected refinance date as closely as possible. A hedge may be unwound early and serve as an effective hedge if a loan refinance occurs before a hedge expiry. Hedge costs tend to go up with hedge term, so hedging to a date well past an actual refinance is not as efficient from a pricing perspective. A hedge that expires prior to a refinance may be extended at an additional cost to the borrower but is less efficient from a pricing perspective (particularly for option products) to do this. It is common for a CRE borrower to enter into a forward starting swap where the effective date matches the expected refinance date, but the cash settlement date is extended for three-to-six months in the event that the refinancing is delayed.
Can forward hedges receive favorable U.S. GAAP accounting treatment?
Public filers (or CRE investors positioning their platforms for a public filing) often seek favorable accounting treatment for hedges to prevent changes in hedge valuations being reflected on their income statement, which creates earning volatility. In general, lock products receive better accounting treatment than option products, and are consequently more commonly employed by public filers like real estate investment trusts (REITs). Given the inherent uncertainty in timing of refinancing and debt issuance, complex techniques are usually required to support favorable U.S. GAAP accounting treatment.
Do you have more questions about forward hedging?
Get in contact with our team of advisors.
Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.21-0344
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