Interest Rate Caps, Floors and Collars

An interest rate cap is a type of interest rate derivative in which the buyer receives payments at the end of each period in which the interest rate exceeds the agreed strike price. An example of a cap would be an agreement to receive a payment for each month the LIBOR rate exceeds 2.5%.

Similarly an interest rate floor is a derivative contract in which the buyer receives payments at the end of each period in which the interest rate is below the agreed strike price.

Caps and floors can be used to hedge against interest rate fluctuations. For example, a borrower who is paying the LIBOR rate on a loan can protect himself against a rise in rates by buying a cap at 2.5%. If the interest rate exceeds 2.5% in a given period the payment received from the derivative can be used to help make the interest payment for that period, thus the interest payments are effectively “capped” at 2.5% from the borrowers’ point of view.

An interest rate cap is a derivative in which the buyer receives payments at the end of each period in which the interest rate exceeds the agreed strike price. An example of a cap would be an agreement to receive a payment for each month the LIBOR rate exceeds 2.5%. They are most frequently taken out for periods of between 2 and 5 years, although this can vary considerably. Since the strike price reflects the maximum interest rate payable by the purchaser of the cap, it is frequently a whole number integer, for example 5% or 7%. By comparison the underlying index for a cap is frequently a LIBOR rate, or a national interest rate. The extent of the cap is known as its notional profile and can change over the lifetime of a cap, for example, to reflect amounts borrowed under an amortizing loan. The purchase price of a cap is a one-off cost and is known as the premium.

The purchaser of a cap will continue to benefit from any rise in interest rates above the strike price, which makes the cap a popular means of hedging a floating rate loan for an issuer.

Interest rate floor

An interest rate floor is a series of European put options or floorlets on a specified reference rate, usually LIBOR. The buyer of the floor receives money if on the maturity of any of the floorlets, the reference rate is below the agreed strike price of the floor.

Interest rate collars and reverse collars

An interest rate collar is the simultaneous purchase of an interest rate cap and sale of an interest rate floor on the same index for the same maturity and notional principal amount.

• The cap rate is set above the floor rate.
• The objective of the buyer of a collar is to protect against rising interest rates (while agreeing to give up some of the benefit from lower interest rates).
• The purchase of the cap protects against rising rates while the sale of the floor generates premium income.
• A collar creates a band within which the buyer’s effective interest rate fluctuates

A reverse interest rate collar is the simultaneous purchase of an interest rate floor and simultaneously selling an interest rate cap.

• The objective is to protect the bank from falling interest rates.
• The buyer selects the index rate and matches the maturity and notional principal amounts for the floor and cap.
• Buyers can construct zero cost reverse collars when it is possible to find floor and cap rates with the same premiums that provide an acceptable band.

Valuation of interest rate caps

The size of cap and floor premiums are impacted by a wide range of factors, as follows; the price calculation itself is performed by one of several approaches discussed below.

• The relationship between the strike rate and the prevailing 3-month LIBOR

1. Premiums are highest for in the money options and lower for at the money and out of the money options

• Premiums increase with maturity.

1. The option seller must be compensated more for committing to a fixed-rate for a longer period of time.

• Prevailing economic conditions, the shape of the yield curve, and the volatility of interest rates.

1. Upsloping yield curve caps will be more expensive than floors.
2. The steeper is the slope of the yield curve, ceteris paribus, the greater are the cap premiums.
3. Floor premiums reveal the opposite relationship.

Interest Rate Caps Can Be Structured

Interest rate caps can take various forms. Lenders have some flexibility in customizing how an interest rate cap might be structured. There can be an overall limit on the interest for the loan. The limit is an interest rate that your loan can never exceed meaning that no matter how much interest rates rise over the life of the loan, the loan rate will never exceed the predetermined rate limit.

Interest rate caps can also be structured to limit incremental increases in the rate of a loan. An adjustable-rate mortgage or ARM has a period in which the rate can readjust and increase if mortgage rates rise.

The ARM rate might be set to an index rate plus a few percentage points added by the lender. The interest rate cap structure limits how much a borrower’s rate can readjust or move higher during the adjustment period. In other words, the product limits the number of interest rate percentage points the ARM can move higher.

Interest rate caps can give borrowers protection against dramatic rate increases and also provide a ceiling for maximum interest rate costs.