FM – L2 – Q89 – Treasury Management

Explain how NorthStar Enterprises can use an interest rate swap to hedge a variable rate loan and calculate the effective borrowing rate.

Question

A company, NorthStar Enterprises, has an outstanding 10-year variable rate loan of $15 million on which it is paying SOFRA + 2%. It wishes to eliminate its exposure to a rise in variable interest rates. Currently, 10-year US interest rate swaps are quoted at 4.458%.

Required:
Explain how the treasury function could use an interest rate swap to hedge interest rate risk and calculate the effective borrowing rate that would result.

Answer

In order to eliminate interest rate exposure, the treasury function should enter into a receive fixed, pay floating 10-year swap at 4.458% with a notional principal of $15 million. Under this agreement, it will pay variable rate (SOFRA) and receive 4.458% on the $15 million notional principal.

Since the company will be both receiving and paying SOFRA on the same principal, these cash flows will perfectly offset. Therefore, the effective rate of finance for the company will be the swap rate, plus the credit margin on the original borrowing.

Thus, the effective interest rate = 4.458% + 2% = 6.458%

Tags: Hedging, Interest Rate Risk, Interest Rate Swap, SOFRA, Treasury management
Level: Level 2

Topic: Treasury Management

Uploader: Samuel Duah