Interest cap warrants are securities used to hedge variable-rate loans. They allow you to limit your interest expense and make it calculable.
Hedging with interest cap warrants
Interest cap warrants have a special position among warrants, as they can only be purchased in connection with variable-rate loans, which involve interest rate risk. In the case of variable-rate loans, rising interest rates immediately reduce the liquidity of the borrower. With interest cap warrants, you obtain an interest cap by paying a one-time premium, thereby limiting your interest rate risk. At the same time, you can benefit from a low-interest expense when interest rates are low. It is not possible to buy interest cap warrants for investment or speculative purposes.
Interest rate hedging by means of an interest cap warrant works similar to an insurance policy. By paying a one-time premium at the beginning of the term, you receive compensation payments in the event that the reference interest rate (3-month Euribor) rises above the selected interest rate cap.
A distinction is made between the following variants of interest cap warrants: bullet, obliterative, part-obliterative interest caps and interest cap warrants with a forward start. One bullet interest cap warrant hedges a volume of 1,000 EUR. Obliterative and part-obliterative interest cap warrants hedge the volume shown in the repayment schedule. In the case of interest cap warrants with a forward start, the hedging starts in the future. Interest cap warrants are available with different interest rate caps (strikes), maturities and repayment schedules to suit your loan. This allows you to decide individually at what level the cap should be, from when and for how long the hedge should run, and whether the entire loan volume or only part of it should be hedged.
Advantages
- The risk of interest rate changes is limited, making the interest expense easier to calculate.
- Borrowers can continue to benefit from low interest rates compared to a fixed interest rate.
- The maximum interest payment and thus the highest possible loan installment burden can be better calculated.
- Interest cap warrants are available with different strikes, terms, and repayment schedules, suitable for all loans and can also be purchased for existing loans.
- They can also be sold at the current market price.
Risks to be considered
- The premium for the interest rate hedge cannot be refunded, even if the reference interest rate is below the agreed cap and it is not used.
- The interest cap warrant does not provide 100% protection for the underlying loan, as the interest cap warrant repays in principal installments and the loan usually repays in lump sum installments. Furthermore, the interest fixing dates of the loan and the interest cap warrant may be different.
- The interest cap warrants limit the interest rate risk, the credit margin is not hedged.
- Investors bear the credit risk of Erste Group Bank AG, i.e., the risk of changes in creditworthiness or insolvency.
- The security is not covered by any deposit guarantee scheme. Investors are exposed to the risk that Erste Group Bank AG may not be able to meet its obligations in the event of insolvency (illiquidity, over-indebtedness) or an official order (bail-in regime). There is a possibility of a total loss of the capital invested.
- In the case of interest cap warrants with a forward start, the period until the start (e.g., December 31, 2027) does not provide any hedging, regardless of the development of the reference interest rate.