Capital Finance

Mark Audigier

Purchasing an interest rate cap could help organizations mitigate their risk with future financings.

It seems like a lifetime ago when Lehman Brothers and Bear Stearns were counted among the top investment banks. Today they are joined by Merrill Lynch, Wachovia, and countless regional and community banks on the long list of financial institutions that have lost their independence or disappeared completely since July 2007.

During the same period, interest rates have gone down 350 basis points, then up 200, and back down again. Short-term implied interest rate volatility, an annualized measure of the market's uncertainty regarding future movements in interest rates, was under 10 percent at the beginning of the crisis. Since then, it has climbed to more than 80 percent, at times spiking above
100 percent. Just about every class of borrower has seen loan spreads skyrocket, while falling asset values have left organizations more leveraged than ever. 

Clearly, the crisis has entirely reshaped the interest rate landscape. Should organizations likewise reshape their approach to managing interest rate risk?

Today's rough terrain is an important consideration for healthcare organizations in determining how to manage an interest rate hedging program, but ultimately, an organization's objectives and the nature of its business cash flows should still determine the program's shape. How might the capital structure change over time? What is the correlation between the organization's interest expense and the cash flows that pay for it? Generally speaking, interest rate risk may be perfectly hedged only if the underlying exposure is known with complete certainty. To hedge effectively, an organization must seek to clearly understand its net exposure and match it to a hedge that takes into consideration the extent to which that exposure is uncertain.

There is a tool in the "hedging tool belt" classically suited to tackle exposures with high uncertainty. Purchased options are the derivatives market equivalent of collision insurance for automobiles. In exchange for a premium, the policy pays out if the driver is involved in an accident. If no accident occurs, the policy pays nothing. A purchased option works much the same way. The purchaser of an interest rate cap, for example, pays an up-front premium to protect against the risk of being broadsided by skyrocketing interest rates.

Purchased options can be a great solution for organizations with highly uncertain underlying exposures, because option purchasers are never exposed to future obligations once they pay the premium. Even if a change in circumstance decreases the hedge's effectiveness, a purchased option does not create any new exposure for an organization.

An Attractive Alternative

Options have value because future interest rate movements are uncertain. Volatility is a measure of that uncertainty. For a given strike rate and hedge amount, the term of the option and the degree of volatility determine the size of the up-front premium. An increase in either increases the price. 

Again, the analogy of insuring against the occurrence of auto accidents, also uncertain, may provide some insight. Intuitively, it makes sense that the more unpredictable a driver is, the more likely that driver will be involved in a collision and, therefore, the more expensive his or her insurance premium will be. At the peak of the bull market in July 2007, after remaining nearly flat for more than 12 months, the market considered the London Interbank Offered Rate (LIBOR) to be a very cautious driver. The two years that followed were a roller-coaster ride. Notwithstanding the Fed-induced stability of the past few months, volatility is very high because the market today is much more wary of LIBOR.

Historically, low LIBOR rates act as a counter to the impact of high volatility on option pricing. Low short-term rates combined with the expectation-however uncertain-that LIBOR will not match its pre-crisis level for the foreseeable future make options an attractive alternative. Like many drivers, option purchasers must find the right balance between the price of the option (the policy premium) and the strike rate relative to the current rate environment (the deductable). A 7 percent, three-year cap on LIBOR will cost much less than a 4 percent cap, though it provides much less protection. Many organizations find that purchased options are well suited to serve as disaster protection. A highly out-of-the-money strike rate may result in affordable protection against the early onset of inflation-fighting federal rate hikes.

Organizations must also consider the term of the interest rate cap. For the same reason that our driver is much more likely to have an accident in the next three years than in the next three months, the longer the option term, the more expensive the price. This relationship also tends to be nonlinear, with an increase in term disproportionately increasing the cap price. For organizations whose exposure to interest rates is longer term, such as our hospital with the new parking structure, purchasing a long-dated interest rate cap may be prohibitively expensive. Alternatively, an organization may reduce the cost by buying a shorter-dated cap initially and renewing it for the remaining term at a later date. 

Even if rates and volatility increase over time, this approach will often result in a lower cash outlay, but it is not without risk. As with auto insurance policies, there is no guarantee that the premium will not dramatically increase when it comes time to renew. Indeed, there are many considerations associated with purchased options. Although they are by no means a panacea, interest rate options may be the best way to deal with the current market conditions for organizations with uncertain risk profiles.

Finding the Right Approach for Your Organization

Today's interest rate environment is indeed an unfamiliar terrain to navigate. Seemingly full of unexpected obstacles yet scarce of credit and product liquidity, this new landscape is difficult to navigate and leaves many organizations with unprecedented levels of uncertainty. Although there is no "compass" that can automatically direct healthcare organizations along the course they should take to navigate today's interest rate environment, the right tool to handle nearly every situation is available to those organizations that know how to select from available conventional hedging instruments. 

For some organizations, the right approach will involve hedging less, rather than more. A shift from swaps to caps may work best for others. As a general rule, organizations should steer clear of exotic products that appear to be an ideal fit initially, but end up doing more harm than good. Starting with a clear understanding of the organization's true exposure, the sound principles of hedging will still lead an organization to the most effective interest rate management program-regardless of the environment.

Mark Audigier is a financial risk management consultant, Chatham Financial, Kennett Square, Pa. (

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