Few days back we had posted an exhaustive set of articles on one of the interest rate derivatives, Overnight Index Swap (Read here). Continuing with that series, we bring you a brief writeup on one more derivatives, interest rate Cap.

Interest rate Cap

  • An interest rate cap is a way of placing a maximum value on a customer’s floating rate index (e.g. Prime, LIBOR, C.P., PSA).
  • For an up-front fee (premium), the customer selects the term of the cap, and the maximum value of the index.
  • The maximum value of the index is called the “strike rate”.

How it Works:

  • The buyer and seller of the cap agree on the term (tenor), the strike rate, notional amount (size), amortization (“bullet”, mortgage, straight-line), starting date and frequency of settlement.
  • If the applicable index resets above the strike rate, then the National City pays the customer the difference between the index and the strike rate times the days’ basis of the reset period times the optional amount outstanding.

Example

  • A company has a $10MM obligation due in 5 years with a lump -sum or “bullet” maturity with National City.
  • The loan is priced at 3 mo. LIBOR + 200 bps. LIBOR is currently 5.75%, giving the customer an all-in rate of 7.75% for the first three months.
  • Expecting that LIBOR will rise, the company would like to “cap” LIBOR so that it does not exceed 8%.
  • The customer buys a cap for three years and pays National City a premium of $125,000.
  • For the next three years, if LIBOR exceeds the strike of 8%, National City will pay the customer the difference between 8% and where LIBOR actually set.

 

Related posts:

  1. Interest Rate Floor
  2. IFRS on Effective Interest Rate
  3. Overnight Index Swap (OIS) – 1