There is no free lunch in markets – a principle worth remembering when evaluating hedging alternatives. Dismissing options-based strategies as 'expensive' because they require a premium, or thinking of swaps as 'cheap' because they don't, fundamentally misses that point. All hedge protection must be paid for, whether with an explicit option premium or contingent swap cashflows.
Today's volatile market environment has increased the potential for expense in swap-based strategies. That volatility, coupled with non-linear interest rate risk profiles among depositories, has increased the popularity of options. We explore several of those options-based strategies below:
Purchased Caps and Floored Swaps
For depositories exposed to rising rates, caps and floored swaps can reduce risk while limiting potential downside should the Fed continue to cut rates.
A cap struck at 4.50% has an annualized premium expense of only 0.25%* per year due to the inversion in the curve
To achieve a similar "one-way" profile, pay-fixed swaps (existing or new) can be combined with interest rate floors to limit potential expense in lower rate environments
In many structures, the initial income earned on a pay-fixed swap can offset the accompanying floor premium expense, creating an option-like hedge without initial expense.
Collars
Depositories concerned about declining rates can use collars for near-term rate protection at a reduced premium expense vs. standalone floors.
Consider a SOFR collar with a purchased floor struck at 3.00% and a sold cap struck at 5.00%
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