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Hedging Interest Rate risk

Long term fixed interest borrowing is often attractive to property investment companies, because it matches long term borrowing with assets that may be held indefinitely. However long term borrowing also has a disadvantage in that you might be locking yourself into a higher interest rate for long periods of time. If interest rates fall for example the property company might not be able to benefit from these interest rates unless it refinances which might have onerous costs.
Another alternative is to borrow money at short or medium term at a variable rate of interest and the hedge the risk that the interest rate will rise further. There are several ways this can be done but all methods have a cost in one way or another
One common method of doing this is known as the interest rate cap. This arrangement fixes the interest rate so that cannot rise above a certain level. This option has a cost which often has to be paid upfront.
To give an example  lets say you are borrowing £100,000,000  at the LIBOR rate of 5% plus 50 basis points so a total cost of 5.5%. But the company feels that they could pay up to 7% without incurring to much difficulty. However if rates rise above 7% this would cause a severe financial strain on the company.

The company could then buy itself an option on the LIBOR rate at 6.5%. Then if the LIBOR rate rises above 6.5% the seller of the option would have to pay the difference on the rate between 6.5 and whatever the rate is above 6.5%.
Another characteristic of this arrangement is that the the cap can be separate from the loan. In other words they are two separate transactions. The cap will reimburses you when the interest rate rises to a certain level.

The cost of the cap varies according to the degree of protection that is required. For example the cost of a cap for an interest rate above 7% is going to be lower than for a cap with protection for an interest rate above 9%. Another factor would be the length of time the hedge is going to run. A hedge for 2 years is going to cost more than a hedge for 1 year.

Another factor is that the cost of the cap can be reduced by selling a floor on the interest rate. This concept can also be illustrated with an example. Lets say that property company Focusnet borrows £100 million and is concerned about the interest rate rising above 7% so it purchases a cap for a certain price. If interest rates instead of going up go down instead, this will result in an immediate benefit to the property company. The property might decide to give up some of this benefit or increased cashflow to the seller of the cap in exchange for the company reducing the cost of the cap. So therefor in our example Focusnet coould sell the saved income if the interest rate drops below 4%. There for the interest rate can only move between 4 and 7%. A cap and a floor  together are known as a collar. It is possible to have a no cost collar which would whereby the amount the property company receives from selling the floor is equal to the cost of the cap resulting in zero cost.

Hedging with FRAs

One of the disadvantages of options is that there is an upfront cost which is the purchase price of the option. This can be avoided with the use of an FRA (Forward rate agreement). Basicly what this is, is a bet on interest rates. The property company simply makes a bet with the bank that if interest rate rise the bank will compensate them and if they fall then the property company will pay the bank. No upfront money is required. In practise however there will be an administrative fee for setting up the arrangementwhich will be less than the cost of a cap for example.