Banks want to protect their yield on a floating rate loan. As such, many banks add floors in floating rate loans.
Have you wondered how an interest rate swap with an embedded floor works? What about the implications for utilizing this structure?
In a loan, when you add a floor, what you are doing is requiring your borrower to SELL the bank an option. The bank, however, doesn’t pay the borrower anything for the option.
Let’s say we pair a normal interest rate swap with a loan that has a floor:
- The borrower could lock in a 10-year swap rate of 3.90% if the loan is priced at LIBOR + 200bps credit spread.
- The floor in the loan is at 1.75% on LIBOR.
If LIBOR stays at or above that strike, then the loan and swap work together in harmony and the borrower has a fixed rate of 3.90%.
Now let’s say LIBOR is 1.50%, or 25bps below the floor added in the loan. What happens?
- The borrower PAYS 3.90% on the swap and RECEIVES 3.50%, so the net swap payment is 40bps.
- On the loan, the borrower pays not 3.50%, but 3.75% because there is a floor.
That means the borrower is paying 3.75% + 40bps = 4.15%, or 25bps MORE than the fixed swap rate.
With the example above, what can be done?
- Option 1 - Do nothing, keep the floor in the loan and no floor in the swap. This will mean if LIBOR goes below the floor strike, then the borrower’s cost of funds will increase (this is called an inverse floater).
- Option 2 - You can insert a floor in the swap. This does have a downside though. In the example shown the borrower sold the bank the floor in the loan and didn’t get paid for it. Now the bank makes the borrower buy back that same floor in the swap, but the borrower must pay for it – in a higher swap rate! This example of a 10-year swap with a floor at 1.75% would add 70bps to the fixed rate, taking it from 3.90% to 4.60%. This makes the bank’s offering uncompetitive and the deal will likely be lost.
- Option 3 - Don’t put a floor in the loan IF THE LOAN WILL THEN BE SWAPPED; let ALCO or Treasury manage the bank’s interest rate risk and the yield of the loan book through macro strategies. This will be the path of least resistance.
We do often see that banks will add a 0% floor in floating rate loans, but not mirror the floor in the swap. As long as the borrower understands that if LIBOR goes below zero, her/his “fixed” rate actually increases then this is an acceptable solution.
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Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved. 20-0057