CFH: Cap/Floor Collars Used as Hedging Transactions 

 

General Information About Cap/Floor Collars

Cap/Floor collars combine the purchase of a cap and the sale of a floor or the sale of a cap and the purchase of a floor.

 

You take out a loan on 01.01 of the current year. The monthly interest rate is variable. The term is one year. On 12.31. the previous year, the interest rate was 3.5 %
To hedge against the interest rate risk, you purchase a cap with a strike of 3.75.
You pay a premium of EUR 1,200. To clear the premium payment, you sell a floor with a strike of 3.25.

This cap/floor collar allows you to hedge against an interest rate that would exceed 3.75. At the same time, you limit profit realized due to a lower interest rate to the amount that you would receive if the interest rate were to drop to 3.25. You need to take into account the uncertainty of interest rate developments in the interest rate spread of 3.25 to 3.75.

 

Mapping Cap/Floor Collars in the System

The system maps cap/floor collars by linking the hedging transactions (cap and floor) with each other using a reference category HMT Reference in Hedge Accounting. You can access the transactions for the references on the SAP Easy Access screen by choosing Treasury and Risk Management → Transaction Manager → Money Market/Forex/Derivatives/Securities  → Back Office Reference (transaction TBR6).

 

Valuation and Effectiveness Test

Usually, you cannot assign more than one hedging transaction to an exposure since the nominal amount of the exposure has already been hedged with the first hedging transaction. Therefore, it is only possible to hedge exposures with cap/floor collars using the reference from category HMT Reference in Hedge Accounting. You can use the reference to assign more than one hedging transaction to the exposure, even if the total nominal amount of the cap/floor collar exceeds the exposure value. In this case, the system checks only the maximum nominal amount of a reference.

The effectiveness test and measurement are carried out separately for each hedging transaction. When doing this, the system compares the values of the underlying with the exposure.

 

Creating a Hedging Relationship

To create a hedging relationship, proceed as follows:

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       1.      On the SAP Easy Access screen, choose Treasury and Risk Management  → Transaction Manager → Hedge Accounting for Exposures → Hedging Relationships → Hedge Plan (transaction THMEX).

       2.        Specify Interest Rate Risk as the risk category.

       3.      Set the Single Hedged Item indicator. If this indicator is set, the system assigns all the loaded exposures (an interest rate instrument or the interest payment in a transaction) to only one hedged item.

       4.      Choose the Hedged Item tab page and select the hedge category Cash Flow Hedge.

       5.      On the Hedging Relationship tab page, specify the first hedging transaction as the hedging instrument. If the cap or floor was assigned to a collar, the fields Reference Category and Reference are displayed.

       6.      Choose the hedge strategy 103 – CF Forward Discounted, Cumulated.

       7.      Create another hedging relationship and specify the second hedging transaction as the hedging instrument. Choose the hedging strategy 103 – CF Forward Discounted, Cumulated.

 

See also:

Cash Flow Hedge (CFH) to Hedge Interest Rate Risk