Calculating Unhedged Interest Expense Under Forward-Rate and Stress-Rate Scenarios

Good to see you again. In the previous lesson, you built the debt-notional schedule: a dated view of the amount actually expected to be outstanding, rather than simply the facility commitment. That schedule is now the principal input to the interest-cost model.

This lesson uses it to calculate unhedged interest expense under a forward-rate case and defined stress cases. The result is not yet a hedge recommendation. It is the baseline evidence needed to show a real-estate client what floating-rate debt could cost under stated assumptions, and how much cash-flow exposure is at stake.

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Define what the model is measuring

For this purpose, unhedged interest expense is the contractual interest payable on the floating-rate loan before taking account of any cap payoff, swap payment, collar payment, derivative premium, or hedge collateral requirement.

It is usually useful to keep these items separate:

Item	Include in unhedged interest expense?	Reason
Loan benchmark interest	Yes	This is the floating component of the loan cost.
Loan margin or spread	Yes	It is part of the contractual loan rate.
Benchmark floor in the loan	Yes	It changes the loan rate even when market rates are low.
Scheduled principal repayment	No	It is debt repayment, not interest expense.
Commitment fee on undrawn debt	Usually no	Track separately as a financing fee; it is not interest on drawn debt.
Upfront loan fees and exit fees	No	These are separate financing costs.
Cap premium, swap payment, or collar payoff	No	Those are hedge cash flows, introduced later.

The core economic relationship is straightforward:

$${\text{Loan Rate}}_t={\text{Applicable Benchmark}}_t+\text{Margin}$$

For a period with a benchmark floor:

$${\text{Applicable Benchmark}}_t=\max \left({\text{Scenario Benchmark}}_t,\text{Benchmark Floor}\right)$$

Then calculate the interest accrued in the period:

$$I_t=B_t^{\text{accrual}}\times R_t\times \frac{D_t}{Y}$$

where:

• $I_t$ is interest expense for period $t$;
• $B_t^{\text{accrual}}$ is the balance that accrued interest;
• $R_t$ is the annual all-in loan rate;
• $D_t$ is the actual number of accrual days; and
• $Y$ is the day-count denominator, such as $360$ or $365$.

The formula is simple; the quality of the output depends on using the loan’s actual benchmark, margin, reset dates, day-count convention, and debt balance timing.

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From forward rates to a scenario interest rate

A forward-rate scenario applies a period-specific benchmark rate to each future reset period. For example, if a loan resets quarterly, the model should contain a benchmark input for each quarterly interest period.

A forward curve is a market-implied set of future rate inputs observed on a particular date. It is useful for planning, budgeting, and comparing hedge alternatives, but it is not a promise about where realised rates will be.

A stress-rate scenario changes those benchmark inputs according to a defined rule. Typical rules include:

• a parallel increase of $200$ basis points across every future period;
• a “higher for longer” case in which expected rate declines do not occur;
• an immediate benchmark shock followed by a gradual reduction; or
• a low-rate case that tests whether a contractual benchmark floor becomes binding.

The scenario rule should be written plainly. For example:

Upside-rate stress: For each quarterly reset date, increase the forward benchmark rate by $200$ basis points. Keep the loan margin, benchmark floor, repayment schedule, and day-count convention unchanged.

That statement avoids a common analytical error: changing several variables at once and then calling the result an interest-rate stress. If the purpose is to isolate rate risk, do not simultaneously assume higher spreads, lower property income, delayed repayment, and a new exit date. Those may be valid combined downside cases later, but they should be separately labelled.

Match the scenario to the loan’s reset mechanics

The benchmark input must reflect the actual loan structure.

Loan feature	Modelling implication
Three-month EURIBOR reset in advance	Use a benchmark scenario for each three-month interest period.
Daily compounded SOFR in arrears	Project an effective compounded benchmark rate for each interest period, or model daily rates if required by the facility.
Benchmark floor	Apply the floor to the benchmark before adding the margin, if that is what the loan agreement specifies.
Quarterly interest payment	Use the actual number of days in each quarterly period and the facility’s day-count basis.
Mid-period draw or repayment	Split the accrual period into dated balance segments, or use a properly calculated time-weighted balance.

A monthly model that simply divides an annual rate by $12$ can be a sensible approximation for internal budgeting. It is not a substitute for the contractually specified calculation when the facility uses Actual/360, Actual/365, daily compounding, or material intra-month balance movements.

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Worked case: quarterly forward and stress-rate scenarios

Assume a borrower has a floating-rate commercial real-estate loan with the following terms:

Assumption	Value
Opening drawn debt on 1 January 2026	USD 20.0 million
Scheduled principal repayment	USD 1.0 million at each quarter end
Benchmark	Three-month term benchmark, reset at the start of each quarter
Benchmark floor	$0.50\%$
Loan margin	$3.25\%$, or $325$ basis points
Day-count basis	Actual/360
Interest payment timing	Quarterly, in arrears
Hedge	None

Because each USD 1.0 million repayment occurs at the end of the relevant quarter, it does not reduce the balance that accrues interest during that quarter. The debt-notional schedule from the prior lesson therefore gives the following accrual balances:

Quarter	Days	Interest-accrual balance	Quarter-end repayment	Closing balance
Q1	$90$	USD 20.0m	USD 1.0m	USD 19.0m
Q2	$91$	USD 19.0m	USD 1.0m	USD 18.0m
Q3	$92$	USD 18.0m	USD 1.0m	USD 17.0m
Q4	$92$	USD 17.0m	USD 1.0m	USD 16.0m

Scenario 1: forward-rate case

Suppose the forward benchmark inputs observed as of the modelling date are:

Quarter	Forward benchmark	Applicable benchmark after floor	All-in loan rate
Q1	$2.20\%$	$2.20\%$	$5.45\%$
Q2	$2.10\%$	$2.10\%$	$5.35\%$
Q3	$2.00\%$	$2.00\%$	$5.25\%$
Q4	$1.90\%$	$1.90\%$	$5.15\%$

The benchmark floor does not apply in this case because every forward benchmark input exceeds $0.50\%$.

For Q2, interest expense is:

$$I_{\text{Q2}}=19,000,000\times (0.0210+0.0325)\times \frac{91}{360}$$ $$I_{\text{Q2}}=\text{USD }256,949$$

Applying the same formula to every quarter gives:

Quarter	All-in loan rate	Unhedged interest expense
Q1	$5.45\%$	USD 272,500
Q2	$5.35\%$	USD 256,949
Q3	$5.25\%$	USD 241,500
Q4	$5.15\%$	USD 223,739
Total		USD 994,688

This is the base planning estimate for unhedged interest on the stated debt schedule. It is not a guaranteed result: actual benchmark fixings will differ from the forward inputs.

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Apply an upside-rate stress

Now apply the stated $200$-basis-point parallel stress to the forward benchmark curve.

Quarter	Forward benchmark	Stressed benchmark	All-in stressed loan rate
Q1	$2.20\%$	$4.20\%$	$7.45\%$
Q2	$2.10\%$	$4.10\%$	$7.35\%$
Q3	$2.00\%$	$4.00\%$	$7.25\%$
Q4	$1.90\%$	$3.90\%$	$7.15\%$

The debt balances and day-counts do not change. Only the benchmark scenario changes.

Quarter	Unhedged interest: forward case	Unhedged interest: $200$-basis-point stress	Incremental cash interest
Q1	USD 272,500	USD 372,500	USD 100,000
Q2	USD 256,949	USD 353,004	USD 96,055
Q3	USD 241,500	USD 333,500	USD 92,000
Q4	USD 223,739	USD 310,628	USD 86,889
Total	USD 994,688	USD 1,369,632	USD 374,944

The declining incremental cost is not caused by the rate shock becoming smaller; the shock remains $200$ basis points in every quarter. It declines because scheduled repayments reduce the balance that is exposed to the higher rate.

This is precisely why the debt-notional schedule matters. Applying a flat annual rate shock to the original USD 20 million principal would overstate the exposure once amortisation starts.

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Test the floor in a lower-rate case

Rate scenarios should also show when a contractual loan floor constrains the borrower’s benefit from lower benchmark rates.

Assume the benchmark falls below the $0.50\%$ floor for the first three quarters:

Quarter	Low-rate benchmark scenario	Applicable benchmark after floor	All-in loan rate	Interest expense
Q1	$0.00\%$	$0.50\%$	$3.75\%$	USD 187,500
Q2	$0.20\%$	$0.50\%$	$3.75\%$	USD 180,104
Q3	$0.40\%$	$0.50\%$	$3.75\%$	USD 172,500
Q4	$0.60\%$	$0.60\%$	$3.85\%$	USD 167,261
Total				USD 707,365

The floor affects the first three quarters. Although the hypothetical benchmark is below $0.50\%$, the borrower pays interest as though the benchmark were $0.50\%$.

This is commercially important when discussing a hedge. A client may say it wants protection against rising rates, but the loan itself may already remove part of the benefit from falling rates. That embedded loan floor should be visible in every scenario model before any derivative terms are considered.

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Build a model that can be reviewed and reused

For a client offering, the objective is not just to produce a number. It is to produce a number that can be traced, updated, and explained to the client, lender, dealer, finance team, and counsel where necessary.

A practical interest-expense tab should include:

Column group	Core fields
Period identification	Period start, period end, reset date, payment date, actual days
Debt balance	Opening balance, draws, repayments, accrual balance, closing balance
Loan terms	Benchmark, floor, margin, all-in rate, day-count denominator
Scenarios	Forward rate, stress adjustment, stressed benchmark, stressed all-in rate
Outputs	Base interest, stressed interest, incremental interest, cumulative interest
Evidence	Source document, as-of date, input owner, confirmed or forecast status

Use clear formula logic. For a simple quarterly loan with a benchmark floor:

$${\text{Benchmark Used}}_t=\max \left({\text{Forward Benchmark}}_t+{\text{Stress Adjustment}}_t,\text{Loan Floor}\right)$$ $${\text{All In Rate}}_t={\text{Benchmark Used}}_t+\text{Margin}$$ $${\text{Interest Expense}}_t={\text{Accrual Balance}}_t\times {\text{All In Rate}}_t\times \frac{{\text{Actual Days}}_t}{360}$$

Where a draw or repayment happens during an interest period, use dated sub-periods:

$$I_t=\sum _{j=1}^m{B}_{t,j}\times R_{t,j}\times \frac{d_{t,j}}{Y}$$

This is more reliable than using only the month-end or quarter-end balance. A USD 5 million draw made on the second day of a quarter produces nearly a full quarter of additional interest; a month-end schedule can conceal that exposure.

Essential controls

Before circulating the model externally, verify the following:

• Basis points are converted correctly. A margin of $325$ basis points equals $3.25\%$, or $0.0325$ in the formula.
• The benchmark and reset date match the loan. Do not use a generic SOFR projection for a three-month EURIBOR loan.
• The floor is applied in the right place. Usually it applies to the benchmark, but the exact contractual wording governs.
• The margin is held constant unless the stress specifically changes it.
• Debt balance timing is correct. A repayment on the final day does not reduce prior days’ accrued interest.
• The day-count convention follows the facility. Actual/360 and Actual/365 produce different amounts.
• No hedge cash flows have been netted into the loan-interest line.
• The scenario date and curve source are recorded. A forward curve is time-sensitive, so its as-of date is part of the result.

A particularly useful client-facing output is the incremental cost against the forward-rate case. “USD 1.37 million of stressed interest” is informative; “USD 375,000 more interest than the forward case over the next year” is usually more decision-useful.

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Key takeaways

Unhedged interest expense is calculated from the debt balance that actually accrues interest, the contractual all-in floating rate, and the loan’s day-count convention.

• Start with the projected debt-notional schedule, not the facility commitment.
• For each period, apply the benchmark scenario, contractual floor, and margin.
• Use forward rates as documented planning inputs, not predictions.
• Define a stress rule precisely, such as a $200$-basis-point increase to every future benchmark period.
• Keep interest expense separate from principal repayments, fees, and future hedge cash flows.
• Where loan balances change inside a period, calculate interest using dated balance segments or a time-weighted balance.
• Record the assumptions, curve date, and contractual source for every material input.

In the next lesson, you will compare the loan’s benchmark, reset dates, tenor, currency, and debt-notional schedule with a proposed hedge, so that apparent protection does not conceal a material mismatch.