‧ Interest rate caps and floors are option like contracts, which are customized and negotiated by two parties.
‧ Caps and floors are based on interest rates and have multiple settlement dates (a single data cap is a “caplet” and a single date floor is a “floorlet”).
‧ Like other options, the buyer will pay a premium to purchase the option, so the buyer faces credit risk.
‧ Caps are also called ceilings because the buyer is protected from interest rates rising above the strike rate.
‧ The payment to the option holder when rates rise above the strike rate is the difference between the market rate and the strike rate, multiplied by the notional, and divided by the number of settlements per year.
‧ Floors set a minimum interest rate payment because if interest rates fall below the strike rate the floor holder is protected; payments are calculated the same as caps.
‧ Floors are commonly employed by floating rate bond holders to protect their rates from falling below a certain level.
Cap Payment = Max[0; Notional × (Index rate - Cap strike rate) × (Days in settlement period / 360)]
Floor Payment = Max[0; Notional × (Floor strike rate - Index rate) × (Days in settlement period/360)]
Cap and Floor Payoffs and Interest Rate Collars
‧ An interest rate collar can be created by buying a cap and selling a floor.
‧ This creates an interest rate range and the collar holder is protected from rates above the cap strike rate, but has forgone the benefits of interest rates falling below the floor rate sold.
‧ When the cost of the floor sold equals the cost of the cap purchased, it is called a “zero cost collar”.
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Caps, Floors, and Swaptions part 1
How Interest Rate Caps Works？
Posted on August 9, 2010 by Manish
An interest rate cap (or ceiling) is an agreement between the seller or provider of the cap and a borrower to limit the borrower’s floating interest rate to a specified level for a specified period of time. Viewed in this context, an interest rate cap is simply a series of call options on a floating interest rate index, usually 3 or 6 month Libor, which coincide with the rollover dates on the borrower’s floating liabilities.
Under a usual transaction, the purchaser of the cap, in return for an up-front fee or premium, is protected against rises in interest rates on its floating rate borrowings beyond a certain nominated upper limit.
If market rates exceed the ceiling or cap rate, then the provider of the cap will make payments to the buyer sufficient enough to bring its rate back to the ceiling level. When rates are below the ceiling, no payments are made and the borrower pays market rates. The buyer of the cap therefore enjoys a fixed rate when market rates are above the cap and a floating rate when interest rates are below the cap.
The payoff of a cap is given by the following formula：
(Index Level – Strike Price) x (# Days in Period / 360) x (Nominal Amount)
For example, suppose a cap has a strike of 6% based upon 3 month Libor, a notional amount of $10,000,000 and the number of days in the period was 90.
If at reset date (day 90) the 3 month Libor rate was at 7%, then the cap provider would pay：(7% – 6%) x (90/360) x 10,000,000 = $250,000
If at reset date (day 90) the 3 month Libor rate was at 5%, then the cap provider would make no payments.
Because the buyer pays an up-front fee, no additional obligations exist from the buyer so there is no residual credit risk.
The following diagram depicts an interest rate cap.
The payoff of a cap is given by the following formula：
(Index Level – Strike Price) x (# Days in Period / 360) x (Nominal Amount)
For example, suppose a cap has a strike of 6% based upon 3 month Libor, a notional amount of $10,000,000 and the number of days in the period was 90.
If at reset date (day 90) the 3 month Libor rate was at 7%, then the cap provider would pay：(7% – 6%) x (90/360) x 10,000,000 = $250,000
If at reset date (day 90) the 3 month Libor rate was at 5%, then the cap provider would make no payments.
Because the buyer pays an up-front fee, no additional obligations exist from the buyer so there is no residual credit risk.
The following diagram depicts an interest rate cap.
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