A Low Cost Tool for Controlling Interest Rate Risk

When most companies think of hedging against rising interest rates, their real concern is mitigating the impact of rising rates on the actual dollar interest payments on outstanding loans and debt issues. Conventional interest rate caps establish a maximum interest rate (i.e. the strike rate) for each interest period and protect not only against sustained high levels of interest rates but also against sharply higher rates in a single interest period. Protecting against the latter effect, however, adds to hedging costs. Hedges which protect against sustained but not transitory rate moves are considerably cheaper than traditional hedges.

A Budget Cap is designed to hedge a company’s exposure only to sustained interest rate movements. It establishes a maximum total dollar interest amount the hedger will pay out over the life of the cap. By hedging dollar interest payments over a longer time horizon, a company hedges its core interest rate exposure at the lowest cost.

How a Budget Cap Works:
To establish the terms of the terms of the cap, the hedger determines how much principal to hedge, the maximum (capped) dollar amount of interest over the caps life, and the final maturity of the cap.

For each interest period, the hedged dollar interest amount is determined by the formula:

Hedge Amount * Actual Number of Days in the Period/360
*min[Market Libor, Cap Rate]

The dollar interest amounts for each period are then added together or accumulated. At the maturity of the cap, the total hedged dollar interest amount is compared to the actual amount of interest paid out over the hedge period. If the actual dollar interest amount is greater than the hedged dollar interest amount, the difference is payable to the buyer of the budget cap.

Benefits of the Structure:

The key advantage of a budget cap is its cost effectiveness. Premiums for budget caps are considerably below the premiums for conventional caps. Budget caps hedge the total interest expense over a specified time period, more clearly matching a treasurer’s needs in the budgeting process.

Disadvantage

Because no payments are made under the cap until the cap’s maturity date, the hedger foregoes the interim cash flow benefits provided by conventional cap hedges.