A business that borrows at a floating rate has made a bet, often without noticing. Its interest line follows the market. While rates are low and stable the bet costs nothing, and the floating rate is cheaper than a fixed one. When rates rise, the interest line rises with them however well the business is doing. It can win the customers it targets and hold its margins and its budget, and still arrive at a covenant test short of coverage because the cost of its debt went up two points in a year.
A buyer looking at that business sees a cash flow that depends on something the business does not control and has not priced, and discounts the equity for it.
Rate Risk is the driver that bounds the bet. It moves levered cash flow by fixing how much of the interest line can move, so that levered cash flow can be forecast when interest rates cannot. With it working, a written policy sets how much floating-rate debt is fixed, swapped or capped and for how long, the instruments sit on the debt schedule with their expiry dates, and every lender pack shows coverage under a sharp rise in rates.
Where Rate Risk sits
Three drivers put the debt in place and keep it there. This essay covers the third.
Debt capacity
- Facility ClosePuts the sized debt in place on documented terms, with the guarantees belonging to the company
- Covenant ManagementTests every covenant monthly ahead of the lender, with a trigger well above the bar
- Rate RiskThis essayFixes how much of the interest line can move, under a written policy
Levered cash flow
Exposure inside a written policy
The policy can be met in two ways. Either a substantial share of the floating-rate debt is fixed, swapped or capped for the period the policy sets, or the rate stress shows debt service coverage holding above the floor.
The either-or is deliberate. A business whose cash flow covers its debt service comfortably even under the stress has no reason to pay for protection it would never use. A business whose coverage would fall below the floor needs protection on a large part of its floating debt. The stress decides, and hedging is one of the two ways to pass it.
Coverage with rates higher
Illustrative. The stress the pack shows every month: debt service coverage if floating rates rose, here by an illustrative two points, on the share of the debt that is not hedged. Headroom is how far cash could then fall before coverage reached an illustrative floor of 1.25. The policy is met if a substantial share of the floating debt is hedged or coverage under the stress holds above the floor.
In the illustration, a two-point rise on $2.8 million of unhedged floating debt takes coverage from 1.52 to 1.40. That clears an illustrative floor of 1.25, though the cash could then fall only 10.5 percent before reaching it, less room than an illustrative safe margin of 15 percent. With three quarters of the debt hedged, coverage holds at 1.49 and the room grows to 16.1 percent.
Instruments are chosen by pricing them against the stress. A swap exchanges a floating rate for a fixed one; a cap limits how high the floating rate can go, in return for a fee. Quotes for each are compared on what they cost against the coverage they protect in the stress, and the choice is recorded. A cap is often cheaper up front and leaves the business the benefit if rates fall, while a swap fixes the cost entirely, so the answer depends on the business's own stress.
Only the person and the instruments named in the policy, drafted under Levered Forecast and approved by the owner before any facility was signed, are used. A finance lead with a view on where rates are heading does not act on it outside the policy. The policy hedges a stress the business has measured, and a hedge placed on a view is just another bet.
Once the exposure is bounded this way, the cash flow no longer depends on where rates go, and the buyer's discount for durability on that count goes with it.
Instruments on the schedule
Every hedging instrument goes on the debt schedule on the day it is executed, with its notional amount, rate, counterparty and expiry and with the confirmation filed alongside. Its accounting is reviewed by the outside accountant in the annual review, with the treatment recorded in the management letter. Hedging instruments have accounting of their own, and a business that skips the review can find its reported earnings moving with the market value of a swap nobody inside understands. Reviewed treatment is what lets a buyer take those earnings as reported.
The schedule also does something simpler. A hedge that is not on it expires without anyone noticing, and the business is fully floating again on a day nobody was looking.
How much to hedge
The policy ratio is set where the cost of hedging and the distress it avoids cross.
Where hedging stops paying
Illustrative. The distress a hedge avoids, less what the hedge costs, both discounted over its term, at different shares of the floating debt hedged. The first steps protect most; later steps cost about the same and protect less.
Distress avoided less hedge cost
The net value peaks near three quarters, the share that keeps headroom under the stress above the bar a lender treats as safe. Hedging beyond that point still avoids some distress, but each step costs more than it saves, so hedging everything is worth less. The policy ratio sits near the peak, where the next step costs as much as it saves.
Show the numbers
| Share of floating debt hedged | Distress avoided less hedge cost |
|---|---|
| 0% | $0k |
| 25% | $24k |
| 50% | $41k |
| 75% | $47k |
| 100% | $30k |
The first part of the floating debt is cheap to hedge relative to what it protects, because it removes the worst outcomes of a rate shock. Each further step costs about the same as the last and protects less, because the exposure that remains is less and less likely to cause a breach on its own. At some point the next step costs more than the distress it avoids, and hedging beyond it moves value the wrong way. The ratio sits at that point.
The same logic sets the finance lead's pay: earned for holding the ratio within a narrow band, and nothing outside it in either direction. Paying for more hedging would buy over-hedging, and paying for saved hedge costs would buy under-hedging.
What happens to a hedge when the business is sold
A hedge outlives the moment it was bought for, which owners tend to forget until a sale or a refinancing.
A swap has a market value that moves with rates. If rates have fallen since it was signed, the business is paying a fixed rate above the market, and ending the swap early costs money, because the counterparty is owed the value of the payments it will no longer receive. If rates have risen, the swap is worth something to the business. When the debt it hedges is repaid, at a refinancing or because a buyer brings its own financing, the swap has to be ended or transferred, and its value on that date is a real payment one way or the other. A buyer will treat a swap with a negative value as a debt-like item and deduct it.
A cap has an upfront cost and no obligation afterwards. It can expire or be left in place, and it never becomes a liability, which is one reason a business expecting to refinance or sell within the hedge's term may prefer a cap even where a swap is cheaper on the day. The choice is best made with the business's likely path in view, and every instrument's current value belongs on the debt schedule, where a buyer will look for it.
What it does to value
Rate Risk ranks sixth on the bridge. The value counted is the fall in the probability of a rate shock and of a breach that comes from the hedged share, multiplied by what those events would cost the owners, less the cost of the hedge over its term, after tax and discounted. A hedge is a yearly cost paid for a smaller chance of a large loss, and both sides are counted.
A hedged business does not get a lower required return. The risk of a rate shock already lives in the scenario file as a probability and a cost, and hedging lowers the probability. Lowering the discount rate as well would count the same risk twice.
What has to be in place first
The instruments implement a policy, so the driver needs the rate stress and the policy from Levered Forecast. The exposure being hedged is the exposure on the debt schedule, which comes from Facility Close. And the business needs a hedging counterparty, often the lender itself, arranged before the facility closes so that the hedge can be executed when the debt is drawn.
Knowing that it works
The pack tracks the share of floating-rate debt hedged against the policy ratio, the months of hedge cover remaining against the policy's minimum, and debt service coverage under the rate stress, every month.
The owner should be able to explain, without the model, what the stressed rise in rates does to the business in dollars of cash flow and in coverage, and to confirm that the business is inside its own policy by reading the policy and the debt schedule side by side.
Why it slips, and what holds it
Floating-rate exposure nearly always goes unhedged the same way: a hedge expires and nobody replaces it. Swaps and caps have end dates, often earlier than the debt they protect, and an expiry is a quiet event.
So each expiry sits on the debt schedule with a replacement date, and replacement starts well before the expiry so that cover does not lapse by default. The policy is reviewed at every refinancing, and no new facility closes without its hedging decided under it.