Interest rate risk presents a credible threat to the company’s debt portfolio. This risk increases significantly if the company has floating rate debt because, in case of a long term floating rate debt, increase in interest rate means a higher interest payment to the lender. Fixed rate long term debt requires a fixed payment of interest and hence is not significantly exposed to the interest rate risks (Saunders & Cornett).
To reduce the adverse effects of rising interest rates, companies try to hedge themselves from the interest rate risks using interest rate swaps, caps and collars. Columbia River Pulp Company Inc. (CRP) has a long term floating debt consisting of $200 million, seven-year reducing, revolving term facility. The use of floating rate debt to finance fixed assets presents a credible risk to the borrower if the interest rate rises. To reduce the risk CRP ponders in several hedging instruments namely interest rate swaps, caps and collars.
Plagiarism Free Work
Best Price Guarantee
100% Money Back Guarantee
Top Quality Work
CRP’s future interest rate outlook suggests that the interest rate outlook would increase from the current LIBOR of 8.375% to 10.75% in January, 1990 and then fall to 9% in August 1991. The United States interest rate forecast suggests that the interest rate would rise over the future years to around 9.6% in 1992. This rise in interest rate would hurt CRP’s debt repayment on the floating rate debt.
The Toronto-Dominion Bank (TD) proposed interest rate swaps to CRP as the most effective interest rate hedging method. The ‘plain vanilla’ swap is an option, which is the swapping of variable rate interest payment with fixed rate interest with the interest payments based on an imaginary or ‘notional’ amount of debt (California Debt and Investment Advisory Commission, 2007). The floating interest payments are based on a three-month LIBOR rate which is paid semiannually.
The interest rate swap proposed by TD is a three-year swap of $50 million. CRP would pay TD a fixed rate of 9.31% in return for a floating rate equivalent to LIBOR which is 8.375% and is expected to rise over the years. This will mean an All-in fixed rate on debt to be 11.31% for CRP for a three year maturity swap. For a longer term maturity of five-year, a fixed rate of 9.57% is to be paid by CRP to TD. In that case the all-in fixed rate will be 11.57% calculated through (LIBOR+ 2%) – LIBOR + Fixed rate.
If the interest rate, rises as per the CRP projections, after one year, the LIBOR would be 10.75%. CRP would still be paying TD a fixed rate of 9.31% in case of a three-year swap deal, saving around 1.44% of the extra interest rate payments it would have been making if the interest rate swap deal is not agreed. However, if the interest rate does not increase as per the forecasts than the swap deal would be costing CRP an extra (9.31% - 8.375%) 0.935%.
The other option available to CRP to hedge against future rising interest rates is the interest rate cap. A cap sets a strike rate or ceiling rate on the interest rate. This option is the most feasible option because it protects against the rising interest rates and allows taking advantage of the declining interest rates. However, the only downside of this instrument is that it involves an upfront fee to be paid (Kawaller, 2009).
TD would sell CRP a one, two, three, four or five year cap on a notional amount for an upfront fee which shall be based on the strike rate and the maturity period based on the indicative market rates. For example, CRP decides to purchase a four year cap of 100 million at 11%, the upfront fee would be 143 basis point times the $ 100 million notional value, which will total $1,430,000. This is a significant amount to be paid as a premium, and it will not be feasible. The premium would only be beneficial if the interest rate rises above the strike rate and TD pays the extra interest payments to CRP.
Interest rate cap would benefit CRP over the swap because the cap will allow CRP to benefit from the declining interest rates, which swap would have locked. The upfront fee put off the CRP board because in case the interest rate was to remain the same or fall than the cap is not required at all and the immense premium that would be paid to TD for nothing.
Interest rate collar seems to be the most attractive option out of all three. An interest rate collar has a cap and a floor simultaneously where CRP would buy a cap and sell a floor to TD.
TD suggested two possible interest rate collars where there are zero upfront fees because the present value of the cap and the floor offset each other. The first suggestion is to purchase a 3 year 11% cap from TD and sell a 3 year 8.375% floor. If the LIBOR rate of the floating debt rises above the 11% cap, TD would make payments to CRP for the excess amount and, on the other hand, if the LIBOR rate decreases below the floor set at 8.375%, CRP would make payment to TD for the decreases interest rates. In this case, CRP would not benefit from the fall in interest rates because the floor shall be set at the current LIBOR rate.
The second suggestion is a three year collar with the cap set at 10.25% and the floor at 8.75% with no upfront fee. However, the floor will not come into effect until after three months. In this case, the floor shall be set above the LIBOR rate, and the cap is lower than the previous suggestion of 11%. The all in rate for the cap would be 12.25%, which is higher than that of the interest rate swap, and the all in rate for the floor is 10.75%. According to the interest rate forecasts of CRP and the United States, in three months, the LIBOR would rise above the current rate and if this rate comes to the floor, than it will benefit CRP because it would not have to pay the interest payments in case of a lower LIBOR.
Swaps, Caps or Collar?
All three instruments are beneficial in their own way, and CRP should probably look at diversifying by getting a combination of them. The interest rate forecasts suggest that the market interest rates would not rise drastically over the next few years, so the interest rate cap would be unfeasible because of the massive upfront fee. CRP should go for a combination of Interest rate swap and Collar.
To protect against interest rate fluctuation, all of the debt should be hedged and not just the minimum amount that is required under the agreement. A 3 year hedging instrument should be bought at least. For a three year period, an interest rate swap is the most feasible option because it presents with the minimum all in rate. For a five year period, a collar with cap at 1.25 and floor at 8.75 is the most beneficial hedging instrument because with the interest rate forecasted to rise. The lower cap at 10.25% would mean payments from TD for the LIBOR above the caped amount.
The best possible scenario would be to hedge half the amount with a three year interest rate swap because the swap rate is beneficial for that period. The remaining amount should be protected by a five-year interest rate collar with 10.25% cap and 8.75% collar. In this scenario, CRP has protected $100 million with a three year swap and the rest of money with a collar. The interest rate cap is not a suitable instrument because the interest rate is not likely to fluctuate by a huge margin for CRP to benefit from the cap and to collect the entire upfront fee that it will pay.
California Debt and Investment Advisory Commission. (2007). Understanding interest rate swap math & pricing. California.
Kawaller, I. G. (2009). Assessing Interest Rate Caps- Alternative to swaps, caps have their own costs and benefits. AFP exchange.
Saunders, A., & Cornett, M. Financial Institutions Management - A Risk Management Approach (Sixth Edition ed.). McGraw-Hill International.
Download Full Answer