Borrowers sometimes find themselves working with a lender that can not offer a fixed rate, either through traditional means or a swap. As an alternative, the borrower could buy an interest rate cap with a strike of 0.00% to synthetically fix the rate at the prevailing swap rate.
Term 5 years
Swap Rate 3.00%
If this borrower could enter into a swap for five years, the fixed rate would be 3.00%. Over the next five years, the total interest paid would be $7.5mm.
Instead, the borrower buys a cap with a strike of 0.00%. The upfront premium for this cap is $7.5mm.
In other words, the borrower is effectively prepaying interest on a 5 year fixed rate.
Here are the projected payments made by the Cap Provider to the borrower. For illustration purposes, we will use annual averages.
Note that the projected payments total $7.5mm, the same as above. This means that at any given moment, the upfront cost equals what the market believes you will pay by floating.
Since we know that a swap rate is nothing more than what the market believes LIBOR will average, this means a borrower is synthetically locking in a swap rate and prepaying the interest.
Think of the upfront cap premium as the fixed rate. The borrower makes a one time payment and prepays all interest on a fixed rate loan.
What happens with the payments made by the Cap Provider each month? Simple – they offset the floating rate payment owed to the lender.
The cap exactly offsets the floating index on the loan, creating a wash. Whether LIBOR goes to 10% or 0%, the cap payment exactly offsets the loan payment.
The borrower is therefore left with the fixed rate plus the loan spread and has synthetically locked in a fixed rate.
Unlike a swap or fixed rate loan, this structure will never have a prepayment penalty. If the loan is prepaid or the borrower wishes to terminate, the residual value of the cap will be paid by the Cap Provider.
Obviously, the most challenging aspect of this structure is the upfront cost. But for borrowers wanting a fixed rate without a prepayment penalty, this structure achieves that.