Interest Rate Protection Agreements: Strategies to Combat Interest Rate Volatility in an Uncertain Market

Description

An interest rate cap agreement is a derivative that can be thought of as an insurance policy against rising rates on a floating rate commercial loan. Borrowers can purchase the cap at loan origination or some later date upon the occurrence of a specified event, such as a relevant index rising above a predetermined threshold. Upon a purchase of the cap, the borrower makes a one-time payment to a counterparty in the rate cap transaction. If the index rises above the agreed-upon threshold, called a "strike rate" or "strike price," the counterparty must make payments to the extent the index is above the strike rate, effectively capping the interest rate for the borrower.

The primary economic components of an interest rate cap are: (1) the notional amount (the size of the cap); (2) the strike rate, and (3) the term of the cap, which is often consistent with the loan maturity. These three factors drive the cost of the cap and can be the subject of negotiations to balance the cost of the cap with the interests of both borrower and lender in limiting exposure to rising interest rates. Once the parties have agreed to the terms, they enter into a long-form confirmation, which outlines the economic and legal terms of the cap and supplements the International Swaps and Derivatives Association (ISDA) Master Agreement--together forming what is referred to as the rate cap agreement.

The loan documents establish the borrower's obligations to obtain and maintain the rate cap. These requirements include the economic terms required for the rate cap and the minimum credit rating for the counterparty to ensure the counterparty will be able to perform its obligations. While interest rate protection agreements are a common and useful way to hedge risk against uncertainty in a floating rate loan, counsel for borrowers and lenders must have a thorough understanding of the potential risks with these agreements to properly advise their clients.

Listen as our authoritative panel discusses the current trends, requirements, market challenges, and key considerations when implementing interest rate protection agreements.