As discussed in recent issues of What Counts, the yield curve has flattened to the point where it is increasingly difficult to obtain sufficient “roll-down” benefit to protect lenders and investors from rising rates. Although most of the flattening has occurred outside of two years, the spread between overnight funds and two-year advances still exceeds 125 basis points. In times such as these, it becomes increasingly difficult to achieve satisfactory funding spreads. The question now becomes: How can I take advantage of the remaining steepness in the yield curve—and protect myself from rising rates?

The Seattle Bank can provide you and your customers with tools to adapt to today’s changing market environment. This month, we introduce the capped, floating-rate advance, a tool that offers the ability to fund at the lowest point on the yield curve, and concomitantly gain some protection in the event rates continue to march in step with the Fed’s move toward a neutral monetary policy.

Consider the following case. Your top-producing loan originator is bidding for a five-year commercial mortgage with viable credit characteristics. You believe that your competitor will offer a fixed-market rate of 6.25% and will fund it with five-year fixed bullet funding at 4.00%, garnering a spread of 2.25%. At the same time, you realize that the potential borrower, too, may wish to benefit from the relative steepness of the short-end of the yield curve. As a result, you offer a choice:

	Fixed-rate funding at 6.25%
	Capped adjustable-rate funding with two options:
		LIBOR + 3.00%, with a 7.00% cap, or
		LIBOR + 2.76%, with a 7.51% cap
	Uncapped adjustable-rate funding at 5.00%, or LIBOR + 2.25%

The difference in spread between the capped and uncapped adjustable options will represent the cost of the interest-rate cap: 75 and 51 basis points, respectively.

In addition to having the ability to borrow from the Seattle Bank on a fixed-rate basis for a five-year period at 4.00%, we’ll assume that you also have the ability to borrow using a range of variable rate options:

	A guaranteed spread advance at LIBOR + 5 basis points
	A capped floating-rate advance at LIBOR + 75 basis points (rate cannot exceed 4.75%)
	A capped floating-rate advance at LIBOR +51 basis points (rate cannot exceed 5.26%)

How Does It Work?
An interest-rate cap is a derivative that protects against increases in short-term interest rates by paying the holder when an underlying interest rate (i.e., the index or reference rate) exceeds a specified strike rate. It is an agreement in which one party agrees to pay the other at regular intervals, over a certain period of time, when the benchmark interest rate (e.g., LIBOR) exceeds the strike rate specified in the contract. The payment period is generally set to align with the maturity of the index interest rate.

The payment for each period is determined by comparing the current level of the index interest rate with the cap rate. If the index rate exceeds the cap rate, the payment is calculated as the difference between the two rates times the length of the period and the notional amount of the contract:

(index rate – cap strike) * (act / 360) * (notional principal)

If the index rate is below the cap rate, no payment is made. The buyer of a cap has a position that is similar to that of a buyer of a call on an interest rate: both benefit when interest rates rise.

Caps are frequently purchased by issuers of floating-rate debt who wish to protect themselves from the increased financing costs associated with an increase in interest rates. By embedding these options into their Seattle Bank advances, members can use these derivative instruments to help manage interest-rate risk, fund loans in portfolio, and meet asset/liability objectives.

Mechanically, a capped floating-rate advance functions like an advance with a known spread over an index, most likely 3-month LIBOR, with the rate of the index capped at an appropriate rate. For example, consider a hypothetical floating-rate advance with the following terms:

First of all, the advance has a final maturity of five years, and there are no call/put provisions. Because the index is three-month LIBOR, payments will be made quarterly, with the rate on the advance adjusting every three months to three-month LIBOR plus the stated spread of 58 basis points. In the event that three-month LIBOR exceeds 4.50% on one of the reset dates, the index will be capped at 4.50%. Thus the advance rate will be capped at 5.08% (1).

To illustrate how this works, let’s assume a member holds a $5-million advance with the terms listed above. If three-month LIBOR is 5.50% on the observation date, the rate on the advance would still be 5.08%, resulting in a payment of $63,500.

Compare this to an advance with a liability index set at three-month LIBOR and a cap (in derivative form) at 4.50%. Assume three-month LIBOR climbs to 5.50%. What would the rate on the liability be? As we know, the periodic payment on the cap can be calculated as follows:

(index rate – cap strike) * (act / 360) * (notional principal)

As shown in the table below, the net cost of the liability and off-balance sheet derivative would be identical to a capped floating-rate advance with similar terms. Both result in a hedge against rising interest rates. The net cash flow for one quarter for the derivative and liability would be as follows:

Valuing a Cap
When determining the value of a cap, it’s important to view the cap as a composition of a number of options, as opposed to just one single option. A cap is composed of a number of interest-rate call options with expirations spanning from the first payment date until maturity. The component options are called caplets. Each caplet has its own expiration date, but typically, the exercise rate on each caplet is the same.

Why are we talking about caplets? Well, it is the discounted values of these caplets that compose the value of the cap. Without going into too much detail on the fun-filled world of option valuation, let’s focus on two variables that will effect the value of these caplets. The first is the interest rate on the underlying index. In general, as interest rates rise, or the curve steepens, the value of the option is going to increase due to the increasing likelihood of the options being in the money. Another factor will be volatility. If interest rate volatility increases, holding everything else constant, the value of the option will increase as well.

Figure 1 shows a five-year history of interest rate cap volatility. Currently, volatility is down significantly from its high in early 2003 (2). With less volatility (and the reduced probability of an option being in the money), the cost of the option is going to be lower than it would have been over the past three years.

Figure 1. Five-Year History of Interest Rate Cap Volatility

Further, the shape of the yield curve is dramatically different than it was two or three years ago. As shown in Figure 2, the curve has flattened substantially.

Figure 2. Three-Year History of Yield Curve Slope

Given the recent decline in volatility and flattening of the yield curve, the cost of purchasing an interest-rate cap has diminished relative to two years ago.

Funding Outcomes Under Multiple Interest-Rate Scenarios
If we match a fixed-rate loan at 6.25% with a 4.00% five-year bullet advance over a period of five years, we gain a spread of 2.25% over the life of the loan. We would achieve a similar result with matched funding on an uncapped variable-rate loan. Now let’s compare the results of funding the following:

	A fixed-rate loan against a capped floating-rate advance
	A capped floating-rate loan against a capped floating-rate advance.

Fixed-Rate Loan vs. Capped Floating-Rate Advances
As shown in Figures 3 and 4, returns generated by funding the fixed-rate loan with capped advances vary with different cap structures. In each of the two structures, returns exceed 2.25% under the flat rate and –100 basis points scenarios. The lowest five-year average return, 1.30%, was generated by the LIBOR + 51 basis points cap structure, under a +300 basis points scenario. The highest five-year average return, 3.60%, was also generated by this structure under a –100 basis points scenario. Thus, the capped scenario in which the funding spread is the lowest generates the highest risk, or variability of return.

Figure 3. Comparative Yields: Funding a 6.25% 5-Year Fixed-Rate Loan with a Capped
Floating-Rate Advance at LIBOR + 75 Basis Points and 4.75% Cap

Figure 4. Comparative Yields: Funding a 6.25% 5-Year Fixed-Rate Loan with a Capped
Floating-Rate Advance at LIBOR + 51 Basis Points and 5.26% Cap

Capped Floating Rate Loan vs. Capped Floating Rate Advances
As shown in Figures 5 and 6, the spread in both iterations of the capped floater strategy shows identical spreads due to the matched funding of the loan versus an identical advance structure. In the event interest rates were to increase, the 2.25% margin could be improved, with relatively little downside in the event of a rate decline.

Figure 5. Comparative Yields: Funding a 5.75% 5-Year Floating-Rate Loan Capped at 7.00%,
with a Capped Floating-Rate Advance at LIBOR + 75 basis points and 4.75% Cap

Figure 6. Comparative Yields: Funding a 5.51% 5-Year Floating-Rate Loan Capped at 7.51%,
with a Capped Floating-Rate Advance at LIBOR + 51 Basis Points and 5.26% Cap

The Best of Both Worlds
The capped floating-rate advance allows financial institutions and their borrowers to:

	Protect against adverse movements in interest rates
	Retain the ability to benefit from lower rates if interest rates fall
	Emulate the flexible benefits of the advance structure to the customer

The Seattle Bank specializes in structuring customized advances, including those with the capped variable-rate feature. Please contact Erick Rendon, business development analyst for further analysis and assistance.

Footnotes:

(1) 4.50% + 0.58% = 5.08%. Please note that it is not the advance rate that is capped, but the index that is capped at the cap rate.

(2) Source: Bloomberg

John Biestman is assistant vice president, IMS consultative sales advisor, and Erick Rendon is business development analyst at the Federal Home Loan Bank of Seattle.

IMPORTANT DISCLAIMER, PLEASE READ: The Federal Home Loan Bank of Seattle ("Seattle Bank") publishes What Counts for educational and promotional purposes only. The data and analysis presented are based upon information obtained from sources that we consider reliable. The opinions expressed represent the current opinions of our staff and are subject to change without notice. We make no warranties, express or implied, regarding the accuracy or completeness of any information, analysis, or opinions presented. No part of this newsletter may be reproduced in any manner without the written permission of the Seattle Bank. The Seattle Bank, its employees, agents, and contractors are not registered investment advisors, financial advisors, or broker dealers, and they are not acting in a fiduciary capacity. The information contained in this newsletter does not constitute a recommendation, offer to sell, or solicitation of an offer to purchase any particular investments or products, including without limitation securities of any companies discussed, and it should not be construed as such. It is the reader’s responsibility to evaluate the suitability, risks, and merits of any investment, funding strategy, or business proposal presented in this newsletter. Newsletter content is for our readers' informational purposes only. Please refer to our Terms of Use for details.