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: Products and Services : Market Risk Management : Interest Rate Derivatives : Treasury Locks, Caps and Collars
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http://www.bmocm.com/products/marketrisk/intrderiv/treasury/default.aspx
tool carries a premium based on market conditions, volatility, term, and the level of protection required. Treasury collars (the combination of buying a Treasury cap and selling a Treasury floor) can be used to hedge current rates within a targeted range. The cap protects against increases in interest rates. The sale of the floor, which eliminates the benefit from a decline in rates below the floor rate, reduces the cost of the hedge. A Treasury collar can be structured at no upfront cost by setting the cap and floor rates such that the premium received for the floor entirely offsets the premium due for the cap. For Example Consider a company that decides today to borrow $100mm for 10 years, with the proposed issue to be priced in six weeks. The company does not want to speculate on the direction of interest rates, and seeks to reduce its exposure until the issue is priced. Until the debt is priced, the company faces exposure to changes in the underlying Treasury rate; and unhedged interest rate exposure can translate into real money. For example, on a $100 million 10-year Treasury with a current yield of 6.56%, the present value of a one basis point change in rates is $72,000! As you can see in the table below, the cost impact of even a small change in rates can be extremely large - higher if rates go up, lower if rates fall. If in markets of even average volatility, intraday rate movements alone can be as much as 15 basis point up or down, consider how much is at risk over the typical 1 to 3 month pre-issue period. Change in Treasury Rate (in basis points) 0 10 20 30 40 50 Present Value of Interest Cost on $100 million Notional $0 $720,000 $1,440,000 $2,160,000 $2,880,000 $3,600,000 Back to top Executing a Treasury Lock To put a Treasury lock into place, the hedger selects an appropriate Treasury note or notes, sets the hedge maturity date (matched to the date when the issue is expected to come to market or the private placement is circled), and agrees to a lock rate with BMO Financial Group.
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At the expiry date the Treasury lock is settled. If interest rates rise during the hedge period, the cost of the company's debt issue will be higher. However, the Treasury yield will be higher than the lock rate, and the cash payment from BMO Financial Group to settle the Treasury lock will help offset higher costs of financing. If interest rates fall during the hedge period, the rate on the new financing will be lower, but the Treasury yield will be lower than the lock rate. This triggers a cash payment to Bank of Montreal, which brings the hedged yield up to the company's original target. From a financial reporting and a federal tax standpoint, current hedge accounting allows the company to recognize the cost or benefit of the hedge over the life of the underlying debt. How Much Does It Cost? The cost of a Treasury lock is determined by the cost to finance the underlying Treasury security over the hedge period. For example, using a 10-year Treasury with a current yield of 6.53 percent where the cost of carry in the government repurchase market is 5.25%, the premium on a six week Treasury lock would be approximately 3 basis points. Thus, the company can lock in a fixed yield on the underlying 10-year Treasury at 6.56 percent. At the end of six weeks, the effective net interest cost for the company's issue would be the fixed yield of 6.56 percent plus its underlying debt credit spread no matter what happens to the market yield on treasuries over that time. Hedging A Large Debt Issue For large debt issues companies frequently set Treasury locks in increments, minimizing the odds of locking-in at a temporary market high point. Hedging one-third to one-half of the principal amount of a proposed debt issue at a time eliminates interest rate risk on a significant portion of the debt and produces a "dollar cost averaged" lock rate. Back to top
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