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Tuesday, 16th September 2025 |
| Increasing demand for more innovative ways of hedging amongst Irish corporates |
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| With ‘caps’ and ‘collars’ now considered by Irish corporates to be too ‘vanilla’, corporates are now looking at new options when looking to hedge their interest rate risk, writes LESLIE COSGROVE, who illustrates how corporates can benefit from ‘window swaps’ and ‘capped floating swaps’ to manage their debt interest rate risk. |
Corporate treasurers now look to their banks for more sophisticated and innovative ways of hedging the various risks that their companies are exposed to. Today’s corporate treasurer not only focuses on cash management, debt interest rate risk and foreign exchange but also on their company’s exposure to inflation, energy and commodity prices.
The challenge for banks, including Bank of Ireland Global Markets, is to work with customers to provide a hedging solution suitable for their particular requirements.
Debt interest rate risk management is currently topical given the increased likelihood of the first ECB official rate hike in the coming months. Gone are the days when the choice was just between fixing the rate on debt or remaining on a floating rate. Fixing via an interest rate swap or fixed rate loan gave full protection against higher rates but no flexibility. Remaining at floating left full exposure to the movements of the market rates and the ensuing impact on interest costs.
To satisfy the appetite of corporate treasurers for more flexibility and sophistication, a range of products is now available to manage interest rate risk. However, it is important that this is not seen as a ‘product push'. Bank of Ireland Global Markets work closely with corporate treasurers to tailor products to suit their interest rate view and the particular financial circumstances that their company is facing. One size definitely does not suit all.
When embarking on implementing the company’s treasury policy, it is important to be armed with as much information as possible to decide on the best product for the company’s needs. To make an informed view on interest rate markets, it is advisable to look back to see where today’s rates are in an historic context, look to the future to see where rates are going and also look at what the fixed market interest rates are pricing in. And finally examine the economic data and any other upcoming events, which may alter the interest rate environment. The resultant view plus the financial plans of the company allows for the most suitable product solution or mix of hedging products to be chosen.
If a corporate treasurer has a view that the interest rate markets are not pricing in enough interest rate increases, the best strategy is to fix via an interest rate swap or fixed rate loan. This gives full certainty as to interest costs over the next few years with full insurance against higher rates.
Caps and collars are suitable if the view is that interest rate markets are being too pessimistic about either the pace or magnitude of future rate increases. Users now consider these products ‘vanilla' as they have been around for a number of years. But they are still very effective in giving the required insurance against higher rates above the cap strike. Their main advantage is that they allow companies benefit if rates stay low or fall. If over the life of the deal, the initial interest rate view that rates will not rise as much as the market was anticipating proves to be correct then the company’s interest cost will be less than if an interest rate swap had been entered into.
As a result of working with corporate treasurers and listening to their interest rate views, we found that many of our customers had a view that euro rates were not going to fall. Many customers also thought that rates were not going to rise in the near future and not to the extent that the market was anticipating. Looking at the market expectations, the view was that too much had been priced into the fixed rates. The following products would suit such a view:
• Window swap: Similar to a vanilla zero cost collar, cap and floor strike rates are chosen which create a ‘window'. There is no upfront premium payable and resets occur at every rollover.
For comparison purposes, a vanilla zero cost collar is 3.55 per cent to 3.05 per cent and fixed rate is 3.30 per cent. (see table 1).
Customer enters into a 5 year swap with maximum/minimum range of 4.00 per cent to 2.20 per cent (window). If interest rates remain between the ‘window', the company’s interest cost is the same as it would have been if the debt had remained at a floating rate. If floating rates go outside of the ‘window', the higher cap strike rate of 4.00 per cent is payable. The worst case rate is known from the outset.
There is full interest rate protection above the cap strike rate of 4.00 per cent if rates rise thereby satisfying many treasury policy requirements for a certain percentage of debt to be fixed. However, if the initial view is incorrect and interest rates fall below the floor strike of 2.20 per cent, the higher cap rate of 4.00 per cent will be payable for that particular rollover period.
This product can also be structured where there is a discount on the floating rate payable when interest rates remain within the ‘window'. (see figure 1).
• Capped floating swap: A capped floating swap is similar to a vanilla interest rate swap except that a lower fixed rate is payable where Euribor sets below a pre-agreed level. For a 5 year capped floating swap, a fixed rate of 3.00 per cent is payable as long as Euribor remains below 3.40 per cent. This compares to a market fixed rate of 3.30 per cent.
If interest rates stay below 3.40 per cent, the lower rate of 3.00 per cent will be payable but if 3 month Euribor sets at or above 3.40 per cent the prevailing floating rate will be payable. However, this rate is capped at 4.20 per cent ensuring that a worst case rate is known. (See table 2 and figure 2).
In summary, how to hedge interest rate risk should be based on a view of the expectation of the future direction for interest rates. Today, hedging products can be structured to suit various views which can prove attractive if the particular view proves to be correct. |
Leslie Cosgrove is head of interest rate derivative sales at Bank of Ireland Global Markets
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