Hedging Future Credit Spread Risk with an Unfunded Loan Commitment

Summary

The document distinguishes interest rate risk from credit spread risk when a borrower plans to draw a floating-rate facility in the future. A forward-starting swap can exchange the future floating reference rate for a fixed rate, but the borrower remains exposed to the loan spread charged by the lender when funding begins. The question asks whether that future spread can be hedged independently.

The proposed solution is to arrange the loan commitment now for the full period, while leaving it unfunded until the future start date. The borrower pays a commitment fee during the waiting period, and the bank commits to the spread in advance. This can lock the financing margin alongside the forward swap’s interest rate hedge. The answer is brief and asserts that banks should be willing to offer such an arrangement; it gives no pricing details, contract terms, or evidence about availability. The practical result depends on lender appetite and the specific commitment and funding conditions.

Key ideas

• A forward-starting swap can hedge reference-rate exposure without fixing the lender’s future credit spread.
• An unfunded loan commitment can reserve financing at an agreed spread before the borrower draws funds.
• The borrower may pay a commitment fee during the period before funding.
• The answer does not quantify the fee or establish that every lender will offer this structure.

Tags

# Is it possible to hedge Spread Risk on a Forward Swap?


# Is it possible to hedge Spread Risk on a Forward Swap?












You can enter a forward swap to eliminate interest rate risk, but the spread risk still exists when the swap actually goes into effect. My goal is to convert a floating rate credit facility that will be funded at a future date into a fixed rate facility.

For example, suppose I take a loan today with a bank for $200mm at 1-Month Libor + 180bps (the "spread"), I can immediately enter into a swap paying 120bps and receiving 1-Month Libor, for an effective rate of 300bps.

Taking this one step further, suppose I enter into a forward swap that begins in 2020 at the same rate, paying 120bps and receiving 1-Month Libor. The only exposure I have left is the spread (The collateral is strong so I'm making the assumption there is no risk to funding the bank loan/credit facility at that time).

I'm not aware of any instrument I can use to eliminate or hedge the spread risk, and no lender (that I know of) will commit to locking in a spread at a future date. Is it possible to hedge this risk?

## Answer by dm63 (score 0)

https://quant.stackexchange.com/a/32132

You can take out a loan for the whole time from now until the end of the forward period, except that from now until 2020 the loan is unfunded, so you just pay an annual commitment fee. Banks should be willing to commit to a spread on this arrangement.

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.