Hedging a Floating-Rate Loan with the Wrong Instrument
A mid-sized manufacturer has a £25 million term loan priced at SONIA plus 250 basis points, resetting quarterly, with four years remaining. The treasury team expects rates to rise and wants to fix its interest cost. A bank proposes a four-year pay-fixed interest rate swap at 4.10% against SONIA, with the company paying fixed and receiving floating. The company's board is uncomfortable with derivatives after a prior loss and asks whether a cap would be simpler. A four-year cap struck at 4.10% costs 1.85% of notional upfront, roughly £462,500. The company's covenant requires interest cover above 3.0x, and current EBITDA is £9 million against annual interest of about £1.6 million.
1. Compare the swap and the cap for this borrower, including the effect on the covenant.
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The swap fixes the all-in cost at 4.10% plus the 250bp spread, about 6.60%, or roughly £1.65 million of annual interest on £25 million. That is close to current interest, so interest cover stays near 9/1.65 = 5.5x. The swap gives certainty but removes the benefit if rates fall: the company pays fixed regardless, and the swap itself would carry a mark-to-market liability if rates decline, which could matter if the lender requires collateral or if the company wants to unwind early.
The cap costs £462,500 upfront, which is a real cash outflow and a P&L hit unless capitalized. It protects against rises above 4.10% while letting the company benefit below that level. Interest cover is unaffected in a rising-rate scenario beyond the premium, and there is no ongoing mark-to-market funding obligation beyond the premium paid.
For a board that is derivatives-averse and a company with a tight covenant, the cap's asymmetry is attractive: it buys protection without creating a liability if rates fall. The trade-off is the premium, which is about 29% of one year's current interest. The company should compare the premium against the certainty value of the swap and consider a lower strike or a collar to reduce cost.
2. The board asks whether either hedge is 'speculative'. Explain how to determine hedge effectiveness and what documentation is needed.
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Neither instrument is speculative if it is linked to actual floating-rate exposure and sized to it. The critical test is that the notional does not exceed the principal of the loan and the tenor does not exceed the remaining term. £25 million for four years matches the loan exactly, so the hedge is proportionate.
Effectiveness should be assessed prospectively and retrospectively. A common approach is the hypothetical derivative method: construct the perfect floating-to-fixed hedge and compare its fair value changes with the actual instrument. The swap should track closely because its terms mirror the loan's reset and maturity. The cap will not be perfectly effective in accounting terms because it is an option, and its value changes are non-linear; the company should expect some ineffectiveness and document how it is measured.
The documentation should state the risk being hedged, the hedged item and instrument, the effectiveness method, the frequency of testing, and the sources of ineffectiveness. Without this, the company cannot apply hedge accounting and may face P&L volatility it did not intend. The board should also note that the swap's mark-to-market can be a liability even while it is an effective economic hedge.