The document provides an overview of interest rate protection devices such as hedges, swaps, collars and caps that are required by lenders. It discusses how financial derivatives like these can be used to manage interest rate risk. The presentation covers types of derivatives including forwards, futures, options and swaps. It explains documentation requirements for interest rate swaps including ISDA agreements and considerations around collateral security. The document concludes with an overview of proposed US regulatory changes around derivatives from the Dodd-Frank Act.

1. Business Law Institute
May 2011
Hedges, Swaps, Collars and Caps – A Primer on
the Wonderful World of Interest Rate
Protection Devices Required by Lenders
Presented by:
Peter J. Rue
Briggs & Morgan
Kevin W. Kaiser
Lindquist & Vennum
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2. Objectives
Overview of financial derivatives
Discussion of how derivatives can be used to manage interest
rate risk
Deal terms, documentation and drafting considerations
Regulatory changes
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3. Financial Derivatives
What is a derivative?
A derivative is a financial arrangement that derives its value based
on the changes in value of some other asset (either a single asset, a
group of assets, or anything that can be valued).
Examples – Stock options, forward contracts, futures contracts,
swaps.
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4. Why do companies use derivatives?
Insulate against risk (hedge)
Profit from risk (speculate)
Tax and accounting
Arbitrage opportunities
Enhance yield
Reduce funding costs
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5. Hedging
Derivatives allow taxpayers to manage risks, including the
following:
 Market fluctuations
 Interest rates
 Credit
 Foreign currency
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6. Why do companies use derivatives?
Many companies use derivatives to limit exposure to
movements in currency exchange rates, interest rates, or
pricing of commodities critical to the business.
A excerpt from a recently filed Form 10-K from a public
company:
“The company enters into contractual derivative
arrangements in the ordinary course of business to manage
foreign currency exposure, interest rate risks and
commodity price risks. A financial risk management
committee, composed of senior management, provides
oversight for risk management and derivative activities.”
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7. Types of Derivatives
There are two broad types of derivatives:
 Forward-based, and
 Option based
 Forward-based derivatives contain both the right and the
obligation to perform under a contract.
 Option-based derivatives provide the right, but not the
obligation, to perform under the contract.
 Swap - a forward-based type of derivative
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8. Types of Derivatives
Forward-Based
Forwards Futures Swaps
Forward Rate Agmt Index Interest Rate
(FRA) Equity Equity
Fx Currency Currency
Commodity Commodity Commodity
Option-Based
Interest Rate Cap or Floor
Put Option (on Equity or Debt Security)
Call Option (on Equity or Debt Security)
Interest Rate Option
Currency Option
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9. Options
One-sided protection/risk
“Calls,” “Puts,” and “Collars”
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10. Call Options
The writer of a call has unlimited downside risk and gain to
the extent of the premium received. The holder of a call
has unlimited upside potential and loss limited to the
premium paid.
Holder’s pay-off curve Issuer’s pay-off curve
Derivative Value
Underlying Price Underlying Price
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11. Put Options
The writer of a put has unlimited downside risk and gain to the
extent of the premium received. The holder of a put has unlimited
upside potential and loss limited to the premium paid.
Holder’s pay-off curve Issuer’s pay-off curve
Derivative Value
Underlying Price Underlying Price
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12. Swaps
Definition
Generally, a swap is an agreement between two parties to exchange
(or “swap”) payments at specified intervals calculated by reference
to an index upon a base dollar amount.
Tax Name – Notional Principal Contract (“NPC”)
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13. Example of a Interest Rate Swap Contract
For example, a swap contract may provide that Customer is to pay,
i.e. counterparty, amounts equal to 7% of $10,000,000 and Bank is to
pay Customer amounts equal to the LIBOR + 2% on $10,000,000.
The reason why Customer enters the swap contract is to hedge
against interest rate fluctuations. Assume Customer has
$10,000,000 of outstanding debt where the interest rate is LIBOR +
2%. By entering the swap contract, Customer is protected against a
rise in interest rates since Customer is effectively obligated to pay
only 7%, regardless of changes in the prime lending rate.
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14. Interest Rate Swap with
Periodic Payment
7 % x $10 mm
Lender Customer Bank
LIBOR + 2% LIBOR x
x $10 mm $10 mm
Payments are netted
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15. ISDA Documentation and Contract Terms
Fixed/Floating Swap
Payments are netted on settlement dates. Net result:
If Floating Rate rises, customer receives payment and can apply
it to interest on the hedged loan, bringing effective overall rate
to the Fixed Rate
If Floating Rate falls, customer pays less interest on loan, but
pays Bank up to the Fixed Rate
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16. ISDA Documentation and Contract Terms
Why Do a Swap?
Fixed Rate not available on loan;
Portability – in theory, swap exists separately from loan and could
be continued if the loan is refinanced (but many swaps require
early termination if loan is repaid)
"Breakage" – For fixed rate loans, breakage goes one-way (from
customer to bank, if fixed rates have declined)
For Swaps, as long as "Second Method" is chosen in schedule,
payment may go either way.
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17. ISDA Documentation and Contract Terms
Documentation
CAP. Caps (bank will pay customer if floating rates exceed a
specified level) can be transactions that are paid for (by
customer) up front, and do not involve credit risk to Bank. May be
a simple contract.
Swaps, Collars (upper and lower limits) and other transactions
require:
ISDA Master Agreement, and related documents;
Approval resolutions; incumbency
Legal Opinion
Documents for any collateral or cross-collateral required (swap
exposure may be required to be covered by same collateral as the
loan)
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18. ISDA Documentation and Contract Terms
ISDA Document:
ISDA Document itself. ISDA has always been and obscure,
difficult document (even for long-time practitioners)
Basic document published in 1987, 1992 and 2002 (1992 is still
most popular) Local Currency, Single Jurisdiction is the one to
use for most transactions
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19. ISDA Documentation and Contract Terms
Defined Terms
Great number of defined terms and concepts. A couple to watch:
Specified Entities – these are written into the events of default and
termination events, so that a default by a Specified Entity will be a
default by the customer
Threshold Amount – the threshold for cross-default; should match
cross default amount in the credit agreement;
Early termination – Preference should be to "Market Quotation" and
"Second Method"
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20. ISDA Documentation and Contract Terms
Other Provisions to Watch
Other Termination Events or Events of Default.
Threshold Amounts (for cross default).
Netting Provisions.
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21. ISDA Documentation and Contract Terms
Collateral Security
It's common for Banks to require same collateral that supports
the loan to support any swap obligations. Issues are:
Personal Property. Covered by Security Agreement (either
specifically or under dragnet clause) and perfected by UCC-1.
Probably few issues.
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22. ISDA Documentation and Contract Terms
Real Property. ISDAs often have a provision in the definition of
'Credit Support Document" that states that any agreement that
supports the loan supports the swap obligations. This raises the
issues:
If ISDA obligation is not described as a secured obligation in the
Mortgage, is it secured?
ISDA may be an obligation separate from the loan and interest on
the loan for Minnesota mortgage registration tax (and equivalent
purposes in other jurisdictions). If MRT is not paid, is ISDA
effectively secured? How much extra MRT should be paid?
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23. ISDA Documentation and Contract Terms
Representation:
Tax Representations
Many ISDAs will require the Customer to represent that it is an
"eligible contract participant" under the Commodities Futures
Trading Commission Modernization Act of 2000
Schedule may include additional representations concerning
capacity to enter swaps, and awareness of customer that Bank is
not advising customer or acting as its representative.
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24. ISDA Documentation and Contract Terms
Governing Law
Rare to have any law but NY govern – this and the real property
issues create issues for customer's counsel requested to give
legal opinion.
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25. ISDA Documentation and Contract Terms
Set Off Provisions
Most 1992 ISDA Schedules have fairly elaborate setoff provisions
applicable on termination of swaps. There are a variety, and are
generally intended to give the non-defaulting party the right to
include obligations to and from its affiliates in an overall netting
of obligations.
2002 ISDA attempts to incorporate these provisions, so they will
not be in the Schedule.
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26. ISDA Documentation and Contract Terms
Foreign Exchange Provisions
If foreign exchange or currency option transactions are
anticipated, the form ISDA will include additional provisions,
including
reference to published ISDA definitions (1998 FX and Currency
Option Definitions)
Often, even more elaborate "netting" provisions. The intent of
these is to net premiums and payments, and also "novation
netting" (which means that if a transaction is entered, then
afterwards a transaction with matching qualities is entered in a
greater or lesser amount, the initial transaction and later
transaction will be deemed terminate, except to the extent of the
increase or decrease in amount).
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27. ISDA Documentation and Contract Terms
Proposed Regulatory Changes and Dodd-Frank
Dodd-Frank Act, particularly Title VII. Signed into law July 21,
2010
Regulations: All are in the proposal phase
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28. ISDA Documentation and Contract Terms
Basic Principles Applied to Swaps
SEC will regulate "security swaps" and CFTC will regulate all
others.
"Swaps Pushout" (called the "Lincoln" rule)
No federal assistance for any swap entity;
Banks will put derivatives activities (except for certain customer
swaps) in a separate, non-insured, entity;
No federal bailout, no "too big to fail“
Mandatory Clearing through a Market or Swap Execution Facility
Registration of Swap Dealers and Major Swap Participants.
Prognosis
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29. ISDA Documentation and Contract Terms
Regulation: The primary regulators of Swaps will be the SEC and
CFTC;
SEC:
Security Swaps – narrower definition, as swaps based on a single
security, debt instrument or narrow index of securities
CFTC:
All "Swaps" (which excludes Security Swaps), including
interest rate swaps
foreign exchange forwards and swaps
credit default index, equity and debt index swaps
total return swaps
commodity swaps
options on all swaps
may exclude certain swaps where physical delivery of a
commodity is intended
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30. ISDA Documentation and Contract Terms
“Swaps Pushout”
Called the "Lincoln" rule after proponent in congress.
There will be no "Federal assistance" for any swap entity (swap
dealers, non-bank Major Swap Participant). This will not apply to
insured depositary institutions that limit swap activity to (i)
hedging related to their own activities, and (ii) swaps that are
permissible for investment by national banks, which should
include customer swaps to hedge interest rates on loans.
Otherwise, Banks will have to put derivative activities in a
separate, non-insured entity.
Premise is no federal bailout; no too big to fail
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31. ISDA Documentation and Contract Terms
Mandatory Clearing
All Swaps outside of specified categories must be cleared on an
exchange - a Designated Contract Market ("DCM") or Swap
Execution Facility. DCMs were created in 2000, but regulatory
underpinning will be changed.
Exception is for end-users, that (i) are not financial entities, (ii)
use swaps to hedge commercial risk, and (ii) notify regulators
how they generally meat financial obligations of non-cleared
swaps
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32. ISDA Documentation and Contract Terms
Registration of Swap Dealers and Major Swap Participants
Specialized – will pass over for this session. Includes capital and
margin requirements.
This will effect markets in which Banks operate;
In effect, all swaps will be "collateralized" and marked to market by
a credit support annex
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33. ISDA Documentation and Contract Terms
Statute set up regulatory framework–execution is to be by regulations
Where regulations stand. Massive sets of proposals published by
agencies including SEC and CFTC (30 regulations, many running
to several hundred pages) were published late in 2010 and early
2011. Mid-April, the comment deadline on the basic regulations
published late 2010 were again extended.
House Republicans, have been urging that rules be pushed back to
2012. Will not be enacted in any law Dodd Frank ran to 848 pages,
published proposed rules to many thousand.
Prognosis – review and comments will continue. Regulations may
start to be finalized late in 2011.
Effect on Lender-required swaps
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34. ISDA Documentation and Contract Terms
Not a complete change – transactions will continue to be done on
ISDA agreements, as one-to-one transactions (not any sort of
exchange)
Markets in which Banks operate will be changed. Economic
effect on the basic interest rate swap market may be subtle.
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35. Derivatives and swaps
Q&A
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36. Contact Information
Peter J. Rue Kevin W. Kaiser
Briggs and Morgan LLP Lindquist & Vennum PLLP
Phone: (612) 977-8638 Phone: (612) 371-2467
E-mail: prue@briggs.com E-mail: kkaiser@lindquist.com
The information contained herein is of a general nature and is not intended to
address the circumstances of any particular individual or entity. Although we
endeavor to provide accurate and timely information, there can be no guarantee
that such information is accurate as of the date it is received or that it will
continue to be accurate in the future. No one should act on such information
without appropriate professional advice after a thorough examination of the
particular situation.
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