Interest Rate Hedging
Interest rate hedges are flexible tools that allow companies to reduce their vulnerability to changes in interest rates. First American Bank provides innovative strategies and products to help our customers manage interest rate exposure and reduce uncertainty.
A hedge is not a loan. It is a separate contract that acts like an insurance policy to protect you from adverse movements in interest rates. Types of hedges include:
- Interest Rate Cap: a separate contract that puts an upper limit on the interest rate of a customer's floating rate loan. Caps provide protection from rising rates, while still permitting a customer to benefit from falling rates. Customers pay an upfront fee for this protection.
- Interest Rate Floor: a separate contract that puts a lower limit on the interest rate of a customer's floating rate loan. Customers receive an upfront fee for giving up the benefit of falling rates.
- Interest Rate Collar: a combination of a Cap and a Floor that puts both an upper and lower limit on the interest rate of a customer's floating rate loan. Collars are often structured as "Costless," so that the fee paid for the Cap is equal to the fee received for the Floor.
- Interest Rate Swap: a separate contract that allows a customer to effectively convert a floating rate loan to a fixed rate for a period of time. There is no upfront cost to a Swap. The cost is built into the rate.
- Forward: a hedge executed today with an effective starting date some specific date in the future. For example, a customer with a balloon payment on a loan due in 6 months could use a Forward Swap to lock in an interest rate for the renewal of the loan, and eliminate their risk of rates rising during the interim period.
Advantages and Benefits to Hedging
- Simplicity: Hedges require no modifications to an existing loan. They can be also used for non- bank debt such as public bonds, subordinated debt and seller notes.
- Flexibility: Because hedges are separate contracts, they allow you to manage rate risk independent of your financing decision. They can be structured to accommodate amortizing or accreting loans, or for a portion of a line of credit. The term of the contract can be shorter or longer than the underlying loan. Forward hedges allow you to lock in rates today for a loan that will close sometime in the future.
- Speed: Once the documents are in place, hedges can be executed in minutes via a phone call.
- Termination: Unlike loan prepayment fees, the cost of terminating a hedge is based on current market conditions. As interest rates drop, the cost will tend to increase. However, as rates rise, the cost decreases. Customers could receive a fee upon termination in a rising rate environment.