Interest rate caps are one of the most efficient ways to hedge against an increase in LIBOR/SOFR and are most commonly used to hedge short term financings. Caps offer multiple advantages over other hedges, like swaps, such as:
- No prepayment penalty
- Dramatically reduced transaction cost
- Can be bid out to a variety of banks to obtain lowest cost and best terms
- Retain exposure to LIBOR/SOFR
Unlike other hedges, the bank does not have credit exposure to the borrower; however, the borrower does have exposure to the bank. An insurance contract is only as good as the company behind it. For this reason, it is critical to negotiate the credit provisions associated with a cap.
As with all transactions, the borrower can give preferential treatment to its lender to reward the relationship while still obtaining the most favorable terms.