Hedging a Floating-Rate Loan: Swap, FRA Strip or Cap
A corporate treasurer has a $50m three-year floating-rate loan resetting quarterly at three-month SOFR plus 150bp. Current three-month SOFR is 5.30%. The 3x6 SOFR forward is 5.10%, and the three-year SOFR swap rate is 4.80%. The treasurer expects rates to fall but wants to ensure the all-in funding cost does not exceed 6.5%. The bank offers three alternatives: (a) a three-year payer swap at 4.80%; (b) a strip of FRAs at the forward rates; (c) a three-year cap at a 5.00% strike for 45bp upfront. The loan has a 1% prepayment penalty in year one. The treasurer asks which hedge best fits the stated objective. Assume no basis between SOFR and the loan reset, and ignore discounting for the comparison. The bank’s credit line requires any hedge to be documented under an ISDA and to have a maximum term matching the loan.
1. Calculate the all-in cost under the swap and the cap, and compare them with the unhedged first reset.
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Unhedged first reset
- 5.30% SOFR + 1.50% margin = 6.80% for the first quarter. This is above the treasurer’s 6.5% ceiling.
Payer swap
- Fixed swap rate 4.80% + loan margin 1.50% = 6.30% all-in fixed. This is below the 6.5% ceiling and removes rate risk, but the treasurer gives up the benefit of falling rates.
Cap at 5.00% strike
- Maximum hedged SOFR cost = 5.00%; add the 1.50% loan margin = 6.50% before premium.
- Premium 45bp upfront. Simple annual amortisation over three years = 45bp ÷ 3 = 15bp per year. All-in maximum ≈ 6.65%, which exceeds the stated 6.5% ceiling.
- If rates fall, the cap still costs the 15bp annualised premium, but the borrower benefits from lower SOFR.
The swap meets the ceiling on a straightforward basis; the cap as offered does not, after the premium is included. The FRA strip locks the forward curve but does not create a hard ceiling.
2. Explain why the FRA strip does not meet the treasurer’s objective even if the average forward rate is below 5.00%.
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An FRA strip locks each quarterly borrowing period at the relevant forward rate. It gives certainty relative to the forward curve, but it is not a cap: if rates rise above the forwards, the borrower’s cost rises with the market after the fixed FRA periods unwind. The treasurer’s objective is a maximum all-in cost of 6.5%, which requires protection against tail increases, not merely locking the current forward curve.
There are further practical issues:
- The strip has multiple trades and documentation, creating operational and credit-line burden.
- The strip may not match the loan if prepayment occurs; the 1% prepayment penalty in year one adds to the cost of unwinding.
- If rates fall, the borrower benefits from lower loan resets but pays on the FRAs, so the net result is broadly the forward curve, not a retained upside.
So even if the average forward rate is below 5.00%, the FRA strip cannot guarantee that a later reset will not push the all-in cost above 6.5%. It solves a different problem from the one the treasurer has stated.
3. Recommend a hedge or combination, addressing the fall-in-rates view and the 6.5% ceiling.
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The stated objective is a hard ceiling, so the recommendation must prioritise that over the rate view.
- If the ceiling is non-negotiable: use the payer swap at 4.80%, giving a known 6.30% all-in cost. It is 20bp inside the ceiling and avoids premium outlay. The cost is giving up the benefit of falling rates.
- If the treasurer wants to retain some fall-in-rates benefit: reprice the cap. A 5.00% strike is too high once the 45bp premium is amortised. Ask for a lower strike, for example 4.85%, and check whether the all-in maximum (strike + 150bp + annualised premium) stays at or below 6.5%. Alternatively, use a collar: buy a cap and sell a floor to reduce premium, but recognise that the floor gives up some downside benefit.
- Do not rely on the FRA strip as the sole hedge if the 6.5% ceiling is a hard constraint.
Given the prepayment penalty in year one, keep the hedge term aligned to the loan and check breakage costs before choosing a structure that may need unwinding.