Interest Rate Hedging
Interest Rate Hedging
November 2007
Interest Rate Hedging
Interest Rate Hedging
Interest Rate Cap
Interest Rate Swap
Notional amount Hedge term Benchmark interest rate
Premium payable
upfront
Strike rate : 5.00% Pay : Fixed at 5.00% Receive : Floating
Initial notional at $34m, amortizing each month for term
Initial notional at $34m, amortizing each month for term
7 years (lease term), effective upon delivery of aircraft
7 years (lease term), effective upon delivery of aircraft
1 Month LIBOR 1 Month LIBOR
Upfront cost of Premium No Upfront cost
Terms of Hedges
Terms of Hedges
ASSET = LEASE LIABILITY = DEBT
Airbus A320 cost $40m 85% floating rate debt : $34m Aircraft placed on lease for 7 years at fixed rental
of $350k per month, priced at 5% Libor assumption
Interest payable at one month Libor plus margin of 25 bps
Deal Example
Interest Rate Hedging
Interest Rate Hedging
Rising Interest Rate Environment
Rising Interest Rate Environment
(Rates increase above 5%)
(Rates increase above 5%)
Interest Rate Cap
Interest Rate Swap
When rates increase in excess of the strike rate of 5.0%, we are reimbursed in cash from our hedge counterparty
Obligation remains under the transaction to pay the fixed rate per the interest rate swap agreement
Full protection is provided against interest rates rising beyond cap level of 5%
Full protection is provided against interest rates rising beyond locked in fixed pay rate of 5%
Cost:The cost is the premium paid upfront; no additional cost incurred during hedge period.
Premium amount depends on the desired protection level, volatility and hedge period.
Cost:No cost upfront and no cost during hedge period. Early termination of swap may require a cost.
Accounting impact: Higher interest rates make the value of a cap increase, which results in a positive
impact to Income Statement.
Accounting impact: Higher interest rates do not increase the fixed pay rate and as a result, there is no
impact to Income Statement.
Interest Rate Hedging
Interest Rate Hedging
Falling Interest Rate Environment
Falling Interest Rate Environment
(Rates decrease below 5%)
(Rates decrease below 5%)
Interest Rate Cap
Interest Rate Swap
We benefit from lower interest rates, which results in lower borrowing costs.
The obligation remains to pay the fixed rate per the interest rate swap agreement.
As interest rates move down, we have the opportunity to re-strike cap to lower rate.
Much lower cost than breaking swap.
Offers greater protection for future.
To terminate an interest rate swap, there will be a break-cost payable to the hedge counterparty
which is subject to market costs.
Accounting impact : Lower interest rates make the value of a cap decrease, which results in a negative impact to Income Statement (limited to
the amount of the upfront premium).
Accounting impact : Lower interest rates do not decrease the fixed pay rate and as a result, there
is no impact to Income Statement.
Interest Rate Hedging
Interest Rate Hedging
0% 1% 2% 3% 4% 5% 6% 7% 8% 9% M ont h 1 M ont h 2 Mont h 3 M ont h 4 M ont h 5 Mo nt h 6 Mon th 7 Mont h 8 M ont h 9 M ont h 10 Interest Interest rate Cap rate Cap with with strike rate strike rate at 5% at 5%
• Graph below illustrates an interest rate cap with a strike rate of 5% over a 10 months. • In months 1-4, as interest rates are higher than the strike rate, we receive compensation from our derivative counterparty.
• When rates fall during months 6 to 10, we pay the lower interest rate - we would not be able to do this if a fixed interest rate swap was in place.
• With caps, we benefit from lower interest rates.
We never pay
We never pay
more than 5%,
more than 5%,
but we can pay
but we can pay
less as rates
less as rates
decline
Interest Rate Hedging
Interest Rate Hedging
Illustrative impact from interest rates movements over term of the lease
(Cap versus Swap with strike rate at 5%)
If Interest Rates average 7%
If Interest Rates average 3% Interest Rate
Swap
Interest Rate Cap
Average Gain or (Loss) per month
(Cap vs. Swap)
Total Gain or (Loss) for 72 month lease
(Cap vs. Swap)
Average monthly inflow or (outflow) from Swap
$50,000 ($50,000)
Average monthly inflow from Cap
$50,000 0
Average monthly cost of Cap premium
($9,722) ($9,722)
Average monthly inflow or (outflow) from Cap
$40,278 ($9,722)
($9,722) $40,278
Interest Rate Hedging
Interest Rate Hedging
The interest rate cap strategy is in place as a result of the
lessons learned from the past, and the fact that one of the
principal risks that aircraft lessors face is a
FALLING
INTEREST RATE ENVIRONMENT
One of the principal reasons that many Pre- Sept 11 vehicles
are under-performing is related to the hedging policies of
interest rate swap employment they had in place at the time
Why did we change from Interest Rate swaps?
Under many hedging policies, a
fixed rate lease
is required to be
hedged by a
fixed rate swap
. When a fixed rate swap is entered into,
an interest rate is locked in that is paid, and floating rate is received
As interest rates rise and fall, the obligation remains under the
transaction to
pay the fixed rate per the interest rate swap
agreement
To understand the impact of this, we need to look at interest rate swaps
that were entered into by ABS transactions in 1999 and 2000, when
interest rates were high, and examine the fall-out
Interest Rate Hedging
Interest Rate Hedging
Why did we change from Interest Rate swaps?
Interest Rate Hedging
Interest Rate Hedging
Why did we change from Interest Rate swaps?
Why did we change from Interest Rate swaps?
In 1999 and 2000, interest rates
increased. Swaps purchased during this time locked
in high pay rates at these levels.
Then rates decreased significantly
between 2001 and
Interest Rate Hedging
Interest Rate Hedging
In late 2001 through 2004, when the downturn came, the transactions were forced to “mark to market” many of their leases either by restructuring with the existing lessee or by repossessing and releasing to another lessee at the then market rate
This meant that on the asset side instead of receiving the old lease rate which was equivalent to an interest rate around 6% to 7% the vehicles were receiving 3% to 4%
However, on the liability side they were not able to mark the swap counterparties to market so they had to continue to pay 6% to 7%, resulting in a huge proportion of the leasing revenues of the vehicles going to the swap counterparties
