Product fundamentals
At a high level, interest rate caps are option products that require a premium and create a synthetic upper limit for the rate on your floating-rate debt. Swaps, on the other hand, allow you to synthetically fix your floating rate at a specific level based on the current forward curve. Because of the fundamental differences between the products, there are a few key factors that drive corporate decision-making across all market environments:
- Cash availability: Caps require an upfront premium payment, so swaps are generally preferable for companies who don’t want an immediate cash outlay.
- Preserving upside: Swaps lock you in at a fixed rate, meaning you will no longer benefit if rates fall more than expected in the future. If you instead buy a cap, you will be able to take full advantage of falling rates (at the cost of your upfront premium payment).
- Level of protection desired: Caps can be ideal for companies that are just looking for protection against extreme, worst-case scenarios, while swaps are ideal for those who want to achieve certainty and protect against even minor rate movements.
- Creditworthiness: Swaps are credit-intensive, as they can become large liabilities over time. As a result, caps are often preferable for corporates with poor credit or limited counterparty relationships.
The role of the interest rate environment
When it comes to market factors, interest rate volatility and the shape of the forward curve are two key inputs to the caps vs. swaps debate. The role of volatility is somewhat straightforward, as high volatility will generally increase cap premiums, making it more expensive for corporates to preserve upside. Swaps, on the other hand, can be ideal in high-volatility periods because they allow you to lock in at the current forward curve without an additional cost. It’s also worth noting that execution fees may be elevated for both products in times of high volatility.
When it comes to the shape of the forward curve, the implications for instrument choice are a bit more nuanced. In the next section, we’ll run through a few common interest rate environments and consider their respective impacts on hedging product choice.
Downward-sloping forward curve (Example: Q2 2023)
When rates are expected to fall soon, swaps gain a unique benefit when you consider expected payments in the short to medium term. In this scenario, the fixed rate you lock in on your swap will be lower than current floating-rate fixings, meaning you’ll see an immediate reduction in the size of your interest rate payments. This can be especially helpful if your company is experiencing headwinds and looking to preserve cash in the short term.
As for caps, the downward-sloping curve will mean that companies can set cap strikes at or around current fixing levels without facing extremely high premiums. This can be attractive for companies who are comfortable with their current interest expense as a worst-case and would like to take advantage of the upside if rates fall.
