FINC 4320 Interest Rate Caps, Floors and Collars Interest Rate Caps and Floors • Cap - a series of European interest rate call options used to protect against rate moves above a set strike level • Floor - a series of European interest rate put options used to protect against rate moves below a set strike level • Recall some basic option valuation points, and apply them to caps and floors: The buyer of a cap receives a cash payment from the seller. The payoff is the maximum of 0 or 3-month LIBOR minus 4% times the notional principal amount. A. Cap = Long Call Option on 3-Month LIBOR Dollar Payout (3-month LIBOR +C -4%) x Notional Principal Amount • If 3-month LIBOR exceeds 4%, the buyer receives cash from the seller and nothing otherwise. • At maturity, the cap expires. 3-Month LIBOR 4 Percent Rate B. Cap Payoff: Strike Rate = 4 Percent* Floating Rate 4 Percent Value Value Value Value Value Date Date Date Date Date Time Interest Rate Caps and Floors Example: a three-year cap, n.p. of $100,000 with a strike rate of 9.6% 13.824% $4224 11.52% $1920 9.6% 9.6% 8.0% 8.0% 6.667% 6.667% 5.556% 4.629% Interest Rate Caps and Floors Example: a three-year floor, n.p. of $1000,000 with a strike rate of 6% 13.824% 11.52% 9.6% 9.6% 8.0% 8.0% 6.667% 6.667% 5.556% $444 4.629% $1370 What about Collars? • Interest rate collar …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. – 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. And Reverse Collars? • Reverse collar …buying 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. The size of cap and floor premiums are determined by a wide range of factors • The relationship between the strike rate and the prevailing 3- month LIBOR – premiums are highest for in the money options and lower for at the money and out of the money options • Premiums increase with maturity. – 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. – upsloping yield curve -- caps will be more expensive than floors. – the steeper is the slope of the yield curve, ceteris paribus, the greater are the cap premiums. – floor premiums reveal the opposite relationship. Putting It All Together • What are the the relationships among swaps, caps and floors? Think about this: • Floor = Cap - Swap • Cap = Floor + Swap • HOW?
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