IRHP FAQs - Financial Conduct Authority

Interest rate hedging product review - FAQs

In addition to the information on the review and redress determination process, and on consequential loss claims, frequently asked questions have been grouped by topics below. Information on the progress of the review is updated on a monthly basis. Please browse through these questions to find out more information about the IRHP review scheme.

If your business is in financial difficulty, consult this page for information on how this affects the review of your interest rate hedging product.

If your question is not answered here, please do not hesitate to contact us.  

Background to the Investigation

Q1: What is an interest rate hedging product?

Answer:

The purpose of an interest rate hedging product (IRHP) is to enable the customer to manage fluctuations in interest rates. These products are typically separate to a loan.

We have identified four broad categories of IRHPs sold:

  1. Swaps; which enable customers to ‘fix’ their interest rate.
  2. Caps; which place a limit on any interest rate rises.
  3. Collars; which enable customers to limit interest rate fluctuations to within a simple range.
  4. Structured collars; which enable customers to limit interest rate fluctuations to within a specified range, but involves arrangements where, if the reference interest rate falls below the bottom of the range, the interest rate payable by the customer may increase above the bottom of the range.

 

Q2: What is an interest rate swap?

Answer:

An interest rate swap is a separate contract to the underlying loan agreement. It is an agreement between two parties whereby one type of interest payment is swapped for another; such as exchanging a fixed interest rate payment for a floating payment.

In practice, if the floating interest rate payment increases because base rates rise, the customer receives an amount that they can use to off-set the increase in loan repayments. Conversely, if the floating interest rate payment decreases as a result of falling base rates, the customer makes an additional payment to the bank under the terms of the swap, but benefits from lower loan repayments. The customer’s costs therefore effectively remain stable. See questions 1-3 under category Scope of the review.

Q3: What is a cap?

Answer:

A cap is a separate contract to the underlying loan agreement that can have the effect of limiting increases in a customer’s loan repayments if interest rates rise.

A customer typically pays an upfront fee and/or an ongoing premium for a cap. The lower the agreed interest rate, the higher the fee.

As interest rates fluctuate, a customer’s loan repayments will fluctuate. If base rates are above the agreed interest rate, the customer receives a payment from the bank that can be set against the increased loan repayments. If interest rates are below the cap, then no payment is made. See questions 1-3 under category Scope of the review for caps.

Q4: What is a collar?

Answer:

A collar is a separate agreement with the bank that limits fluctuations in interest rates within certain pre-agreed levels. There are two types, explained below.

Simple collar

A simple collar involves a ceiling and a floor. As interest rates rise, loan repayments will increase, but increases are capped at the rate agreed as the ceiling. Similarly, as base rates fall, any reductions in loan repayments are limited to the rate agreed as the floor. See questions 1-3 under category Scope of the review for simple collars.

Structured collar?

Structured collars are in some respects similar to simple collars. They enable customers to limit interest rate fluctuations to within a range. However, while the ceiling functions in a similar way, the floor is more complex and customers can end up paying increased interest rates if the base rate falls below the floor. They require a more difficult assessment of the benefits and risks. See questions 1-3 under category Scope of the review for structured collars.

Q5: What is a simple collar?

Answer:

A simple collar involves a ceiling and a floor. As interest rates rise, loan repayments will increase, but increases are capped at the rate agreed as the ceiling. Similarly, as base rates fall, any reductions in loan repayments are limited to the rate agreed as the floor. See questions 15-17 for the scope of the review for simple collars.

Q6: What is a structured collar?

Answer:

Structured collars are in some respects similar to simple collars. They enable customers to limit interest rate fluctuations to within a range. However, while the ceiling functions in a similar way, the floor is more complex and customers can end up paying increased interest rates if the base rate falls below the floor. They require a more difficult assessment of the benefits and risks. See questions 15-17 for the scope of the review for structured collars.

Back to top >