Hedging a Floored SARON Loan with a SARON OIS Payer Swap
A Swiss pension fund owns a real-estate subsidiary that has drawn a CHF 45 million five-year floating-rate loan. The loan pays daily compounded SARON in arrears plus a 110 bp margin, with a 0% floor on the SARON component. The fund's investment committee expects the SNB to raise rates over the next 24 months and wants to cap the loan's interest cost without refinancing. A bank offers a five-year SARON OIS payer swap at 0.95% versus compounded SARON, or alternatively a two-year swap at 0.70% that can be rolled. The fund's collateral policy allows posting cash but not bonds, and the fund wants to minimise cash drag. The loan agreement permits early repayment only with a break cost. The treasurer notes that the loan's floor means the fund does not benefit if SARON turns negative, while the swap would still settle negative SARON against the fixed leg.
1. Explain how the SARON OIS payer swap hedges the loan and why the 0% floor creates an asymmetry.
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A payer swap pays fixed 0.95% and receives compounded SARON. Ignoring the floor and compounding differences, the all-in cost becomes SARON + 1.10% plus the swap's fixed-minus-floating payment, which equals 0.95% + 1.10% = 2.05%. The floating exposure is largely removed. The floor changes the result when SARON is negative. The loan sets the SARON component at 0%, so the borrower still pays the 1.10% margin. The swap, however, still receives negative SARON, which means the fund pays the fixed rate plus the absolute value of negative SARON. The all-in cost becomes 2.05% minus SARON, which is above 2.05% when SARON is negative. The swap therefore overhedges the downside relative to the floored loan: the fund fixes its cost in positive-rate scenarios but does not get the full benefit of negative rates. That asymmetry should be quantified before choosing the hedge.
2. Compare the five-year payer swap with a two-year roll and recommend an approach given the collateral policy and rate view.
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The five-year payer swap locks in 0.95% for the full loan tenor and eliminates roll risk. If the committee's view that rates rise over 24 months is correct, locking now may be cheaper than rolling a two-year swap at 0.70% and then refinancing at an unknown rate. The two-year roll has a lower initial fixed rate but exposes the fund to higher rates at roll date and to repeated execution and collateral costs. Against the five-year swap, the fund gives up the chance to benefit if rates fall, and it must post cash collateral under its policy, creating cash drag. The two-year roll also requires cash collateral but for a shorter expected period. Given the strong view and the desire to cap cost without refinancing, a five-year payer swap is defensible, but the fund should size it to the loan's expected outstanding balance and retain a cash buffer for variation margin. If cash drag is binding, a partial five-year hedge with a smaller notional is preferable to an unhedged position.