Interest rate hedging With suitable mortgage products or interest rate derivatives
 

Interest costs are a key component of any financing package and generally comprise a base interest rate and a margin. The long-term base interest rate in particular can fluctuate significantly, which can put the success of your investment at risk. This is why, regardless of the financing instrument you opt for, you should think about the level of predictability you want for your interest costs (over the entire term of the investment) as well as your capacity for interest-related risks (risk of rising interest costs).

Hedging through targeted product selection

Regardless of the type of financing, suitable products can help you reduce the negative consequences of rising interest rates, or even eliminate them entirely. The following options are available to you:

  • Combining different terms to maturity: diversifying the interest rate fluctuation risk by staggering due dates/terms to maturity
  • Forward contracts: setting up financing with a fixed interest rate (e.g. fixed loan) before the cut-off date for payment. This can also be used when refinancing to hedge the interest rate risk in advance
  • Switching to a different product: if the type of contract (e.g. Libor mortgage) allows it, or once a fixed-interest period has expired

Hedging using interest rate derivatives

Interest rate derivatives tailored to your specific requirements let you hedge your financing arrangements against interest rate fluctuation risks. This makes it easier to plan, and protects your company against unfavorable interest rate trends. Interest rate derivatives are particularly suitable for mid-sized and larger companies or real estate companies, since a certain minimum volume is required. There are various hedging instruments available and their individual advantages and disadvantages should be analyzed in detail based on the client's circumstances. Although swaps are one of the most common interest rate derivatives, they can entail a number of disadvantages in a negative interest rate environment. If LIBOR is negative, you will also pay LIBOR for the swap in this period. This increases the cost of financing, as negative LIBOR must be paid on the swap and the LIBOR for calculating loan interest rates for financing cannot be lower than zero.

The risks of interest rate derivatives based on the example of swaps 

  • When you conclude a swap, you are no longer able to benefit from lower interest rates for financing.
  • If you decide to terminate the swap early, you may incur costs depending on the market situation.
  • A swap always involves the actual LIBOR, even if it is negative. In the current interest rate environment, this increases financing costs. 

An example: interest rate swaps

In an interest rate swap, a fixed interest rate is swapped against the current Libor interest rate, based on a pre-defined nominal value for a fixed period. Concluding an interest rate swap costs nothing, since both parties agree to make interest payments in the future.

The start date can be immediate or years in the future. This is a simple way to hedge future financing arrangements in particular, since the swap rate can be fixed now. The effective financing is taken out on the basis of Libor at the time of financing, and then rolled on a short-term basis over the term of the financing.

Example of using interest rate swaps

Example:

  1. A swap always involves the actual LIBOR, even if it is negative. In the current interest rate environment, this means that the client pays LIBOR to UBS. 
  2. For fixed advance payments, the higher of the current LIBOR or 0.00% is always used

Example: a swap starting in the future

You agree at the time of concluding the swap to pay a set interest rate ("swap rate") over the term of the arrangement. In return, you receive a variable interest rate from the bank (for example CHF three-month Libor).
You roll over the fixed advances based on the applicable CHF three-month Libor.
A swap always involves the actual LIBOR, even if it is negative. In the current interest rate environment, this means that the client pays LIBOR to UBS. For fixed advances, the higher of the current LIBOR or 0.00% is always used. This increases the cost of financing when LIBOR is negative. 

Contact our specialists

We’d be happy to advise you on all aspects of financing and show you interest rate hedging options that can be specifically tailored to your needs. Please contact us.

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