For many years, various European banks require an interest rate hedge as a condition to extend loans. This requirement provides them with an opportunity to increase the performance of their operations via the hedges, in which they include margins, credit spreads and provisions.
Banks normally propose an Interest Rate Swap (IRS), upon which the borrower pays a fixed rate in exchange of a variable rate that is netted out with that of the loan. Usually, borrowers accept to pay a fixed rate that is higher than the current variable rate.
In addition, the IRS bears some market risk, which means that its mark-to-market changes as interest rates fluctuate. If both parties agree on an early termination and current interest rates are higher than the contract fixed rate, then the borrower will receive a premium. However, if rates are lower, then the borrower will be required to pay a premium.
Our monetary system, as it is conceived, together with central banksâ€™ objective of moderate inflation and crusade against deflation, provokes a tendency toward low interest rates. This is shown by the evolution of interest rates in most developed economies in the last few decades. For this reason, the implementation of an IRS has caused more regret than satisfaction.
It is convenient to bear in mind that there are multiple ways to hedge interest rate risk other than IRS. There is a broad range of products between the two extremes: variable rate and fixed rate. For example, Caps, Collars, or other structured hedges combine the advantages of a variable rate with those of a fixed rate hedge:
- The borrower can pay interests at the variable rate and benefit from eventual interest rate decreases.
- The borrower is still hedged against interest rate hikes, fulfilling bankâ€™s requirements.
- The risk of early termination is significantly diminished, which allows the bank to decrease their counterparty risk provisions.
- The borrower can implement risk management policies other than just fixing rates for 100 or 75% of the loan â€“as usually required by banksâ€“, which may not be financially optimal.