Back-up Expensive? – no, cancellable
Friday, December 04, 2009As old Central Bank wisdom would have it „the enemy of lower Interest rates is lower interest rates.“ As a result of the flooding of money and investment markets in the course of the banking and financial crisis, fear was stirred up globally about whether issuing banks were acting timeously and proportionately to counter nascent devaluation and attendant fast-rising interest rates.
At this stage, interest rate forecasts are only heading „north-eastwards“ (graph 1).
Graph 1: 3M-EURIBOR forecast
Source: Bloomberg
Graph 2: Steepness of the EUR yield curve
Source: Bloomberg
This is also shown clearly by the steepness of the interest curve (graph 2), i.e. the difference between short-term and long-term money and spoils the enjoyment of currently low money market interest rates. From a historic perspective, the price of a switch between a 3-month fixed-interest deal and a 10-year fixed interest deal of over 2.5%, appears extremely high. This spread (i.e. the difference between short- and long-term inter-est rates) is normally about 1.5%.
With careful observation and intelligent exploitation of the prevailing situation, so-called cancellable (fixed interest payer) swaps offer a very interesting means of hedging. Cancellable swaps are designed as hybrid products offering security and economic efficiency. Fundamentally they distinguish between extendable swaps and genuine terminable swaps.
| Payer Swap (Cash+10 Years) | Extendable Swap (5+5 Years) | Multiple Cancellable Swap (5+5 Years) | |
|---|---|---|---|
| Description | Defined fixed interest rate for the entire duration. Termination for both parties only possible at the prevailing market value (positive or negative). | Specially created interest swap underwhich the Bank, at the end of the first period, has the right to extend at the same interest rate or not extend, as the case may be. If the Bank elects to extend, a swap also exists for the second period. | Specially created interest swap under which the Bank has the right, on expiry of a preliminary period (variant: at various previously determined due dates), to cancel the deal. The interest rate during the preliminary period is known in advance. |
| Current Coupon Rate | 3.54% | 2.71% | 2.64% |
| Costs | None | Positive interest reduction | Positive interest reduction |
| Costs at termination | Always the current cash value of the deal | None if not extended; otherwise prevailing cash value | None if terminated; otherwise prevailing cash value |
Both rights of the bank – extension or actual termination – offer the prospect (from the customer’s viewpoint) of a discounted interest rate. This does not come cost-free. In the worst case in both variants, the customer can find himself without security where the bank exercises its right to terminate. If interest rates have generally increased, security on the residue will need to be arranged at higher rates. With extendable variants particularly, the opportunity risk of an extension must not be ignored.
This occurs if interest rates have fallen in the meantime and the bank considers an extension at the agreed fixed rate to be attractive.
Interest rate hedging isn’t a game in which the highest card always wins. Rationality is everything. If the various bank products aren’t fully understood, hands off! On the other hand, the strength of hedging products lies in the broad range of their potential forms.
Swaption functionality in sals.a
