Rate floors and basis risk in a hedged loan

A hedge can offset the intended rate exposure only to the extent its terms match the loan. Floors and benchmark differences can leave a property with higher costs even when the debt is described as hedged. The owner should quantify the residual exposure rather than assume every SOFR reference moves identically.

Create a loan-and-hedge comparison covering benchmark, observation date, tenor, reset frequency, floor, notional, day count, payment dates and fallback terms. Classify each difference by its cash effect. Some are deliberate structuring choices; others are avoidable mismatches that should be resolved before execution.

Identify the exact benchmark on each contract

An overnight rate, a compounded historical average and a forward-looking term rate describe different measures. A shared acronym is insufficient. Record the full name and administrator together with the observation date and any adjustment or rounding.

The New York Fed explains that its SOFR Averages compound historical observations over specified calendar-day periods.^[1] Those averages differ from the daily overnight SOFR and should not be treated as a forecast of the coming month. The distinction matters when a hedge references a different measure.

The ARRC's business-loan conventions separately address Term SOFR, SOFR Averages and their observation and interest periods.^[2] These are recommended conventions, not proof of the terms chosen by a specific lender or hedge provider. Use the signed loan and confirmation to determine the actual exposure.

Quantify benchmark basis using gross cash flows

Consider an original hypothetical $105 million interest-only loan with a 2.4% spread. Assume its 31-day actual/360 period uses a 3.75% Term SOFR fixing. A pay-fixed swap on the same notional pays 4% but, deliberately for this mismatch example, receives a 3.2% historical-average fixing over the same period.

Gross loan interest is $556,062.50 at a 6.15% coupon. The swap's net payment is $72,333.33 because its received benchmark is below its 4% fixed rate. Combined cash interest is $628,395.83.

If the hedge instead received the loan's same 3.75% fixing with matching conventions, combined interest would be $578,666.67, equivalent to 6.4% over that period. The mismatch adds $49,729.17. It equals the 0.55% fixing difference on $105 million for 31/360 of a year.

These are invented rate settings to expose the arithmetic, not a forecast of the relationship between Term SOFR and averages. The basis can change sign or magnitude. A one-period difference should not be assumed constant for the remaining term.

The New York Fed's methodology also distinguishes publication timing and observation conventions.^[1] A model should preserve the dates used, not merely a monthly rate label. Differences in observation timing can matter during a period of rapid rate movement even if the contracts reference related measures.

Analyze a loan floor separately from basis

A loan floor can prevent the benchmark charged on the debt from falling below a contractual level. An unmatched swap may continue to receive the actual lower rate, increasing the combined amount the borrower pays.

Chatham's floor explanation demonstrates this mechanism and discusses aligning the swap or loan structure.^[3] It does not establish the cost of an embedded floor for another transaction. Obtain a quote for the exact approved hedge and compare it with retaining the mismatch under stressed low-rate cases.

For the hypothetical $105 million loan, assume a 3% benchmark floor and now use the same 2.2% benchmark on both loan and swap, isolating the floor effect. Loan interest is $488,250 at the floored 5.4% coupon. The 4% pay-fixed swap adds $162,750, giving $651,000 of combined interest.

The effective combined rate is 7.2%, rather than 6.4%, because the loan charges 3% while the swap receives 2.2%. The 0.8% difference adds $72,333.33 during the same 31-day period. Keep this separate from the earlier benchmark-basis scenario; the two illustrations should not be added unless they occur together under an explicitly defined combined case.

Evaluate remedies through approved terms

Potential remedies include a loan-floor change, matching treatment in the swap or a different hedge structure. Each changes economic or legal terms and may require lender or counterparty approval. Compare the premium or rate increment with the exposure removed across several scenarios.

Chatham's discussion identifies the possible additional cost of embedding a matching floor.^[3] A lower quoted swap rate can be accompanied by a larger residual floor risk. Record the chosen tradeoff and establish that ownership understands the circumstances in which combined interest rises.

A cap should also be reviewed against the loan floor and index. It limits positive exposure above its strike under its own terms; it does not force the loan's floored benchmark to decline. If the lender mandates a particular hedge, proposed changes must satisfy that covenant rather than only improve the owner's spreadsheet.

Check day counts, resets and settlement timing

Two contracts with matching benchmarks may use different dates or accrual conventions. Prepare a test payment using both gross legs and the loan bill. Check initial stubs, month ends, holidays, shortened periods and actual notional changes rather than test only an ordinary 30-day month.

The ARRC discusses day counts, business-day conventions and lookbacks as separate drafting choices.^[2] A recommendation that uses actual/360 does not establish that both executed instruments use it. Follow the documents and identify any approximation in a long-term sensitivity model.

Receipt timing creates liquidity risk even when the economic amounts offset. A property may need to pay full loan interest before receiving hedge cash. Identify the receiving account, lender controls and whether netting is authorized. A month-end net number alone cannot show the cash needed on an earlier payment date.

Review fallback and document interactions

Ask what happens if a benchmark is unavailable, replaced or calculated differently. Compare adjustments, decision rights and effective dates on both contracts. An initially matching exposure can cease to match after a change if the provisions operate differently.

Chatham's legal training explains that confirmations contain trade economics and that ISDA schedules can include transaction-specific elections and termination events.^[4] These documents need to be reconciled with the loan rather than regarded as generic paperwork appended after the price is negotiated.

The training also discusses loan-covenant incorporation, additional termination events and credit-support linkages.^[4] Have counsel determine whether modifying a loan rate or replacing a benchmark affects the hedge, its security or its termination rights. An economic remedy should not inadvertently create a separate cash obligation.

Finish with a mismatch register that names the difference, shows its tested cash effect, identifies the approved remedy or accepted residual exposure and assigns ongoing monitoring. Reproduce a high-rate, below-floor and unusual-calendar payment. That turns “hedged” into a precise statement about protected exposure and makes the remaining risks visible to ownership before they appear in a payment shortfall.