New services offset interest rate risk - interest rate swaps, caps, and floors

Healthcare Financial Management, Oct, 1990 by Mark C. Gossett

Interest rate risk is not a new issue. Because of interest rate volatility, healthcare institutions long have been exposed to increasing debt costs or falling investment returns.

Recently, however, new services have emerged to manage that exposure. Although an array of services is available, the most commonly used are interest rate swaps, caps, and floors. Interest rate swaps

An interest rate swap allows an organization to convert an asset's or liability's interest rate from fixed to floating, or vice versa, without altering the underlying investment or debt. No principal is exchanged in a swap.

It is an off-balance-sheet transaction allowing an organization and a counterparty to exchange a series of interest payments based on a set principal amount and two separate interest rates. The counterparty can be the firm's lender, investment manager, or another party.

In swapping to convert a floating rate of interest to a fixed rate, a healthcare institution receives a series of floating rate payments from a counterparty. These payments would be based on the same interest rate index as the institution's debt payments.

At the outset, the institution would agree to pay the counterparty a fixed rate of interest over the life of the transaction. The rate usually is expressed as a spread plus the yield of a U.S. Treasury note for the same term as the swap. No other fees or costs normally are incurred.

Because the floating rate an institution receives offsets its floating debt interest payments, the institution effectively is left with a fixed rate of interest. Healthcare providers also can swap to convert the yield on assets from floating to fixed or from fixed to floating, depending on balance sheet structures, exposures to rate movements, and rate projections. Interest rate caps

An interest rate cap allows an organization to set a maximum on the index that determines its floating rate debt costs. Like swaps, caps may or may not be executed with a lending bank. An organization pays an upfront fee to guarantee payment if borrowing costs rise above the cap level.

For example, a healthcare organization might purchase a cap from its bank to hedge a prime rate borrowing, limiting its exposure to the prime rate fluctuating above 12 percent for three years.

If the prime rate increases to 13 percent during that time, the organization would continue to pay the higher rate to the bank. However, the bank would pay the difference between the 13 percent prime rate and the 12 percent cap level, bringing the borrower's effective maximum interest cost back to 12 percent.

The difference between a cap and a swap is that a swap effectively fixes an organization's interest cost, so it will not incur higher costs if rates rise and will not benefit if rates fall. A cap sets a maximum on a floating rate but allows a company to enjoy lower costs if rates fall.

The fee charged for a cap varies with the length of time the cap will remain in effect, the principal amount being capped, the level at which the cap is set, and market rate forecasts. Interest rate floors

Interest rate floors provide protection against declining yields on variable rate investments. The mechanics mirror those of an interest rate cap. An investor pays an upfront premium for the right to be paid if rates fall below a specified level.

If rates fall below that level, the company will receive a lower return from its variable rate investment. However, it also will receive a payment from the floor seller for the difference between the market yield and the floor rate, bringing the effective yield back to the floor rate.

Like caps, interest rate floors allow an organization to protect itself from adverse interest rate movements and to benefit from favorable shifts in market rates.

Healthcare organizations should evaluate their exposures to interest rate risk by studying debt costs, investment yields, and the net effect that changing market conditions could have on their finances. By examining available risk management options, they can prepare to take appropriate steps as their financial objectives evolve and as market conditions change.

Mark C Gossett is second vice president of the Northern Trust Company, Chicago, Hi. He specializes in designing interest rate management programs for corporate clients, including many healthcare institutions.