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Article

Interest rate floors: economic and hedge accounting impacts

Date:
June 1, 2020

Summary

If your refinancing discussions with lenders include considering a change to interest rate floors, you should evaluate the potential hedging and hedge accounting impacts of this transaction.

Key Takeaways

  • Lenders are adding interest rate floors or increasing the floor strike rates in new financing deals.
  • Swap rates are extremely low and embedding a matching floor can increase the swap rate, perhaps almost doubling it.
  • Before executing or amending a swap, you should determine the swap rate with the floor embedded, considering the reduced credit exposure.
  • If you add or modify a floor in an existing credit agreement being hedged, the floor mismatch could significantly impact hedge accounting and potentially trigger de-designation.

In response to the increase in demand for liquidity and the decrease in interest rates within today’s volatile market conditions, bank lenders are adding interest rate floors or increasing the floor strike rates in new financing deals to protect minimum interest payouts.

With many corporate loans now including 1% and 0.75% floors, organizations are increasingly evaluating whether to embed offsetting floors in new swaps, whether to amend existing swaps, and how best to model the hedge accounting ramifications. If you are in discussions with your bank lenders around refinancing and considering a change to interest rate floors, you should evaluate the potential hedging and hedge accounting impacts of this transaction.

Hedging implications

Swap rates are extremely low and embedding a matching floor can increase the swap rate, perhaps almost doubling it. Before executing or amending a swap, you should determine the swap rate with the floor embedded, considering the reduced credit exposure. In particular, higher floors (e.g., 1%) should have a significantly reduced credit profile. Your analysis should include all the visible and hidden cost components in relation to your overall economic objectives for the transaction, such as credit and execution charges, gain/loss on trades, floor costs, model discrepancies driven by market volatility, and other factors.

This is a chart of interest rate floors swap pricing

Swap rates are extremely low and embedding a matching floor can increase the swap rate, perhaps almost doubling it.

Before executing or amending a swap, you should determine the swap rate with the floor embedded, considering the reduced credit exposure.

Hedge accounting mismatches

For hedge accounting, an interest rate floor is considered a critical term of the hedging relationship. If you add or modify a floor in an existing credit agreement being hedged, the floor mismatch could have a significant impact to the effectiveness of the existing hedging relationship and potentially trigger immediate de-designation. Would a mismatch between the hedged loan and the hedging instrument cause a hedge accounting failure now or in the future? This could depend on the swap maturity, floor strike, testing method, and documentation language.

Strategic and operational support

Chatham partners with hundreds of corporates from both an economic and hedge accounting perspective. Our team of hedging and hedge accounting specialists can support you in:

  • Determining whether embedding offsetting floors in new swaps is cost effective and, if so, how to best structure the transaction, select a counterparty, and achieve the most efficient pricing.
  • Modeling and assessing the hedge accounting implications, ensuring you achieve both your economic and hedge accounting objectives.

If your organization is concerned with issues surrounding floors, Chatham can provide guidance in determining and quantifying any mismatches between your debt and derivatives. Complete the below form to arrange a 20-minute phone conversation with our team, where we can offer customized insights, ideas, and suggested next steps.


Schedule a call

Talk to a hedging or hedge accounting advisor about market impacts on your hedging program.


Disclaimers

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.

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