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The
meeting

You know for a fact that the interest rate environment is of particular interest to Michael, and so you decide to invite a Global Markets Specialist, Sarah, to the meeting so she can add value to the initial conversation.

Click on Sarah and Michael to follow a part of their conversation. For more detailed information, click on the buttons, below.
Sarah (Global Market Specialist) and Michael Wilson having a meeting
Sarah says:

I’ve reviewed your financial statements and details of your existing loans and hedges. You currently have total debt of $22m, and I see you also have a hedging facility for $12m, fixed at 3.2% that’s not expiring for another 18 months – is that correct?

Yes, I have another 18 months remaining on my Fixed Rate facility and because the fixed rate is higher than the current market, my Bank quoted me an Early Termination Cost if I am to break out of it. I do not wish to break out of the hedge, so I have a feeling I’d need to wait 18 months before I consider refinancing to Commonwealth Bank.

Let’s take a look at the details of the hedge… It’s an Interest Rate Swap, which may be able to be novated across to the Commonwealth Bank if you decide to refinance. We’ll need to have a look at it in more detail when we are assessing your credit application.

Ok, great, it’s good to know that if I decide to refinance, that you will consider novating across my existing hedge so I don’t need to terminate it. In that case, let’s progress this conversation, and look at an application to refinance the debt of $22m and borrow an additional $3m for renovations on one of our shopping centres.

I would also like to understand if there is anything I can do about my interest costs for the additional finance I am seeking and what options I have on my existing debt given the Interest Rate swap I have.

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Interest Rate Swap

An Interest Rate Swap allows your client to achieve a fixed rate for a floating interest rate borrowing facility, giving them a known cost of funding over the term facility. The client pays a fixed rate and receives a floating interest rate at each roll over. The two amounts are netted, resulting in one payment made either to or from CBA. The underlying floating interest rate facility will be rolled at the applicable floating interest rate. When combined with the Interest Rate Swap transaction, this achieves a fixed exposure.

Graph of interest rates

Benefits of Interest Rate Swap

  • Provides you with protection against potential future increases in interest rates above the agreed Swap rate during the term of the Swap.
  • Known cost of funding where the term of the hedge matches the underlying borrowing facility.
  • Forward starts are available to match borrowing and hedging objectives.
  • There are no upfront fees or commissions.
  • Rights and obligations of both parties are clearly established.
  • A market instrument that has the ability to be novated to another financial institution.

Risks of Interest Rate Swap

  • Usually involves an immediate increase in your cost of funds over short-term interest rates.
  • Unable to benefit if floating interest rates remain low or fall below the agreed Swap rate.
  • Roll over dates of the Swap must match the interest payment dates of the underlying floating interest rate borrowing facility in order to maximise Swap protection.
  • You may incur a cash flow differential should rollover dates, rate-sets or notional of the Swap not match the underlying floating interest rate borrowing facility.
  • You may incur a termination charge if the Interest Rate Swap is terminated early (prior to the maturity date), the value of which will increase or decrease depending on fluctuations in prevailing market rates and time, and can be significant.

Novation

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Novation is the act of substituting one party in a contract with another, or of replacing one debt or obligation with another. It extinguishes (cancels) the original contract and replaces it with another and requires the consent of all parties involved.

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