Interest Rate 'Caps'
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Interest Rate ‘Caps’ Overview Purpose : Protect yourself from higher interest rates on your borrowings Flexibility : You Select your ‘Cap’, or your max interest rate, and length of time of cover Payments : Receive the difference between market interest rates and your ‘Cap’ level Premium : Once off payment provides cover for 3 / 5 / 7 years at selected rate Independent : ‘Cap’ is not tied to a property or specific bank loan Bank Margins : No requirement to alter your existing (low) bank margins Risk : Loss of premium if interest rates do not exceed your ‘Cap’ level. What is an interest rate ‘Cap’ ? An interest rate ‘Cap’ is a derivative that seeks to protect investors from higher interest rates in the future. Investors purchase a ‘Cap’ with an upfront premium, selecting a maximum level of interest rates and for a specified term. In return investors shall receive a series of quarterly payments once market interest rates exceed the selected ‘Cap’ level. How does the ‘Cap’ operate ? With No ‘Cap’ in place, the cost of borrowings rise as interest rates rise Interest Cost ‘Cap’ at 3.5% limits the impact of higher interest rates in future As interest rates rise, (reference to 3 month Euribor), and exceed the ‘Cap’ level of 3.5%, the ‘Cap’ pays investors the difference between these interest rates. Payments are calculated on a daily basis and payable quarterly to investors. For example a 3.5% ‘Cap’ would pay 2% of the nominal amount when rates reach 5.5%. Note the ‘Cap’ level is exclusive of the margin payable by investors on their existing bank borrowings. Cost of the ‘Cap’ ? The premium or cost of the ‘Cap’ is calculated and paid for upfront. The drivers of the cost are the term of the cover and the level of the interest rate selected. The longer the term of the cover the more expensive the ‘Cap’, and the lower the interest rate the more expensive the premium. Warning: Investors may lose the premium invested if interest rates do not exceed the level of the ‘Cap’ over its term. Interest Rate ‘Caps’ Interest rates to rise ? Our belief is that interest rates are currently too low, and that given a choice central banks would have rates at levels far higher than are prevailing at present. Quantitative easing, expanding US money supply, coupled with lower interest rates has in our opinion kick started this process in the form of higher commodity prices. We believe that this will in time feed into higher interest rates as occurred in response to stimulus packages and inflation post the 1987 Stock Market Crash. Euro Rates at 0.8% from 5.4% in Sept 2008 1989 German Rates from 3.5% to over 10% Source Bloomberg What next for interest Rates ? •Source Bloomberg* •Past Performance is not an indicator of future performance. The value of your investment may go down as well as up. Advantages of ‘Cap’ versus Fixed Rates Protection : Protection from higher interest rates on your borrowings Flexibility : Tailor the Cap’ to limit cash flow implications of higher rates Margins : No renegotiation of bank margins from low level to ‘new’ margins of 2-3% Cash Flow : No immediate rise in interest costs, which remain low while rates are low Termination : Potential to sell the ‘Cap’ at market prices before maturity Disadvantages of ‘Cap’ versus Fixed Rates Premium : If rates do not exceed your ‘Cap’ the premium is not refunded Your bank : Your bank is not involved in the ‘Cap’ Margin : Your bank may renegotiate your margin in the future and dilute the ‘Cap’ Termination : Early termination may result in a loss of premium Cost of the ‘Cap’ ? 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