Arcadia Logistics: Swap versus Cap on Variable-Rate Debt
Arcadia Logistics has $200 million of five-year variable-rate debt priced at SOFR + 175 bp. SOFR is 4.30%, so the all-in rate is 6.05%. The board wants to cap annual interest expense at $14.0 million and is considering either a pay-fixed swap at 4.20% or a 4.50% cap with a 0.60% annual premium on the notional. The company's marginal tax rate is 25%, and its bank requires a 10% credit valuation adjustment on derivative exposures. The CFO believes rates will fall within 18 months but wants protection against a 150 bp rise.
1. Quantify maximum annual interest under the swap and the cap, and recommend one.
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Debt is $200 million. Current SOFR 4.30% + 1.75% = 6.05%, or $12.1 million of interest. Swap: fixed 4.20% + 1.75% = 5.95%, or $11.9 million regardless of SOFR. Cap: strike 4.50% + 1.75% = 6.25% maximum loan rate; premium 0.60% × $200 million = $1.2 million per year. If SOFR is at or below 4.50%, interest is SOFR + 1.75% + 0.60%. At 4.30%, that is $13.3 million. If SOFR is above 4.50%, loan interest is capped at $12.5 million plus the $1.2 million premium, or $13.7 million.
Both stay under the $14.0 million board limit. The swap gives lower certain cost but eliminates downside if rates fall. The cap costs $1.2 million per year and retains downside. If the CFO genuinely expects rates to fall within 18 months, the cap is the better match; if the board prioritizes budget certainty, the swap. A 50% swap plus cap is a compromise.
2. What should treasury consider for hedge accounting and counterparty credit?
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Document the hedging relationship at inception: forecasted variable-rate interest payments, risk management objective, and effectiveness method. A pay-fixed swap can qualify as a cash flow hedge; the cap also can, but premium accounting and amortization must be specified. Test effectiveness prospectively and retrospectively. A 150 bp rate move is within a reasonable range, but if the notional or term does not match the debt, ineffectiveness arises.
Counterparty credit: the bank's 10% CVA requirement means derivative exposure is not free; collateral thresholds, ISDA and CSA terms, and credit limits matter. A cap is an asset to the company if rates rise, creating counterparty exposure; a swap is an asset if rates fall. Do not choose the hedge solely on accounting, but if hedge accounting fails, profit and loss volatility may undermine the board's objective.
3. Given the CFO's view that rates may fall, propose an alternative structure and its trade-offs.
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Use a collar: buy a 4.50% cap and sell a 3.50% floor to reduce or eliminate the premium. If SOFR stays between 3.50% and 4.50%, the company pays near-market; above 4.50%, the cap protects; below 3.50%, the floor limits the benefit. Alternatively, hedge 50–60% of notional with a swap and leave the rest floating, or use a swaption or cancellable swap.
The trade-off is giving up downside below the floor in exchange for lower upfront cost. The collar must be sized to the debt and documented; the sold floor creates a liability if rates fall, which may conflict with the CFO's view. A partial swap preserves some downside while providing budget certainty on the hedged portion.