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Market Update

Hedging costs update — November 8, 2021

November 8, 2021


The Fed has started tapering its purchase of bonds, signaling a potential end to quantitative easing (QE). This has occurred in the context of a market that has pulled forward expected timing for a rate hike from the Fed. These factors have driven a rapid increase in hedging costs, particularly interest rate caps.

Key takeaways

  • On Wednesday, November 3, the Federal Reserve announced that they would begin the process of their QE tapering, cutting bond purchases by $15B monthly from their current pace of $120B/month.
  • This largely anticipated action marks a move toward a less accommodative stance by the Fed and caps a month that saw short-term rates almost double as the market pulled forward timing for a rate hike from the Fed.
  • In the context of this rate environment, interest rate cap costs have increased substantially, the second such notable move this year.
This past Wednesday, the Federal Reserve announced that they would begin tapering the bond purchases that make up their quantitative easing (QE) program, an anticipated move that marks a shift toward a less accommodative monetary policy. Their currently $120B/month purchases will be wound down by $15B per month, a pace which implies an end to QE in June of next year if the Fed doesn’t subsequently reverse course.

Tapering has always been viewed by the market as a necessary precondition for the Fed to begin raising rates. While the Fed has cautioned that tapering should not be viewed as a signal that the Fed is preparing to raise rates, it has occurred with the backdrop of a market that has pulled forward its expected timing for rate increases, particularly as concern has mounted over the past month that supply chain pressures and energy prices would drive inflation to be more than “transitory”. As of close of business Thursday, Fed Fund futures imply a greater likelihood than not of a hike coming in June of 2022 and a second by November the same year.

Target rate probabilities (bps)

Source: CME Group

The relative speed with which these expectations have changed is notable, and illustrated well by looking at the forward curve for SOFR and how it has changed over the past month (SOFR, derived from repo rates, is highly correlated with the Fed Funds rate and the forward curve for SOFR is a good reflection of market expectations for Fed Funds). As recently as October 1, the market was pricing in less than a single 25 bps increase in rate by end-of-year 2022, compared to two 25 bps increases currently.

SOFR forward curves

From our clients’ perspectives, the unfortunate consequence of this change in market sentiment has been a significant increase in hedging costs, particularly for the interest rate caps that that are often purchased at the requirement of lenders on floating-rate loans for transitional assets. The tables below compare current cap costs to pricing at the beginning of October. In some cases, the cost of structures commonly purchased by commercial real estate (CRE) borrowers have more than doubled.

Indicative cap pricing (bps on loan amount)

The shift forward in expectations for rate hikes make the direction of these pricing moves intuitive. If short-term rates are expected to rise more quickly, a dealer bank selling a cap might expect that it is more likely they will need to pay out to a borrower that buys a cap, which pushed pricing up. Looking at two- and three-year swap rates (which reflect, conceptually, what short-term rates like LIBOR and SOFR are expected to average over the next two and three years, respectively), we see that they have increased significantly in the past month, with the two-year rate almost doubling and the three-year rate nearly doing so as well.

SOFR swap rates

In the context of these rate movements, this increase in cap pricing is more explainable, if no less palatable. It also highlights one of the incongruencies between CRE markets and interest rate derivatives markets – the latter tend to be much more volatile, which can make deal underwriting more difficult as hedge pricing can fluctuate significantly between the signing of a term sheet and the closing of a loan. As these pricing movements occur, it’s helpful to understand the different ways loan cap requirements and loan structures may be adjusted to make them more affordable. Springing caps (which defer the requirement for a borrower to purchase a cap until such a time when a certain interest rate threshold is hit), step-up strikes (which have strike rates that increase in the latter years of a cap when an asset is presumably cash flowing more strongly and more NOI may be underwritten), and simply reducing the term of the cap (from three years to two years, for example) are all structures we’ve seen employed as cap pricing has gone up and it becomes a more material consideration when underwriting a transaction.

If you’d like to understand any of these approaches better, please reach out to your Chatham representative to discuss further.

Contact a Chatham expert

Reach out to the Chatham team to discuss the recent increase in hedging costs


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

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.