A good number of corporate borrowers over the last eighteen months who have been forced (by interest rate hedging policies/limits) to fix rates for terms beyond 12 months have chosen to use swaptions and swaption collars as the method of fixing. The swaption strategies have paid off handsomely for those who understood the risk/reward equation and were not afraid to pay cash up-front for option premiums. Borrowers who purchased 12 month swaptions for swap terms of 3 to 7 years a year ago when swap rates were pushing 8.50%, are now able to walk away from the option and borrow at fixed swap rates near to 7.00%. The premium cost disappears as insignificant when measured against the 1.5% pa interest saving that has been achieved, against the alternative at the time of entering straight swaps at 8.50%.

Several NZ companies were acquired by Private Equity funds in early 2007 and had to deal with the substantial increase in company debt levels as the PE owners extract maximum leverage from their investments. The lending banks in these transactions make fixing of interest rates to 75% for terms of three and five years a condition of the loans. Last year APRM advised a high use of swaptions and swaption collars as the method of hedging to meet these compulsory requirements.

Care should be taken when using swaption collars, as the sold floor option (where the bank will exercise on the borrower) should be set at a strike-rate which the borrower can comfortably live with in terms of budget and multi-year business plan interest costs. Just reducing the net option premium paid should not be the only consideration when entering collars. As market swap rates started to tumble a few months ago, some borrowers bought the sold floor options back from the bank, to remove the obligation to fix at that level. APRM has observed a wide divergence in pricing between the banks on swaptions and swaption collars. Banks obviously price-in the credit usage to different degrees. How competitive their pricing is on swaptions also depends on the position of their own option book.