Interest Rate Cap

1. Characteristics 

An Interest Rate Cap is a contract that guarantees a maximum level of Libor. A Cap can be a guarantee for one particular date, known as a Caplet. A series of Caplets, or Cap can extend for up to 10 years in most markets. Caps are also known as Ceilings. In return for making this guarantee, the buyer pays a PREMIUM. Caps generally guarantee a maximum level of either 3 or 6 month Libor or whatever the prevailing floating rate index is in the particular market. The clients maximum loss on a Cap transaction is the premium.

A Cap is a series of sequentially maturing European style call options that protect the purchaser from a rise in a floating rate index, usually LIBOR , above a predetermined level. The purchaser has the right to receive a periodical cashflow equal to the difference between the market rate and the strike, effectively placing a maximum limit on interest payments on floating rate debt. In the Yen market caps usually have maturities of 1 to 10 years and are based on LIBOR. The standard reset frequency is 3m for 1 year and 6m for 2 years out to 10 years, other reset frequencies are possible, e.g. 1 year against 1m, but uncommon. The standard amount is Y10 billion.

As usual with OTC options all parameters of the cap are negotiable but the bid-offer spread will widen as the cap becomes more complicated and therefore the transaction cost may increase substantially. Many participants in the market will absorb any mismatch risk between their position and a more standardised cap structure to take advantage of the cheaper cost and greater liquidity.

2. Cap pricing

The cap is a series of European style call options (caplets) and its price is the sum of these caplets.
The dominant pricing method in use is the Black-Scholes option pricing methodology. However the simplicity of the Black-Scholes model is tempered by its assumption that short term interest rates are constant. Options on short term interest rate will only have value if rates are stochastic ie not completely predictable. Therefore many other stochastic interest rate models have been developed by financial economists to compete with the Black-Scholes model as the definitive derivative pricing model for market participants.

Using financial models it is possible to imply an expected value for each caplet at its maturity and a fair value for the caplet will be the present value of this expectation. The price of the cap will be the sum of these present values.

The higher the strike compared to prevailing interest rates the lower the price of the cap. High strike Out of The Money caps will be cheaper than At The Money or low strike In The Money because of the reduced probability of the caplets being in the money during the life of the option.

The price of the cap will increase with the length of the tenor as it will include more caplets to maturity.

In the market traders will use volatility to quantify the probability of changes around interest rate trends. Higher volatility will increase the probability of a caplet being in the money and therefore the price of the cap.

3. Cap applications

Banks and institutions will use caps to limit their risk exposure to upward movements in short term floating rate debt. Caps are equally attractive to speculators as considerable profits can be achieved on volatility plays in uncertain interest rate environments.

Assuming prevailing short term interest rates are 5% a Bank with floating rate debt concerned over a potential rise in rates may purchase for example a 6% cap. Any minor fluctuations in rates must be carefully managed by the Bank but any substantial rise to 6% or above will be hedged by payments from the writer of the cap. If the Bank considers that the potential for rate rise is only in the short to medium term it may purchase a cap for a 2 or 5 year maturity and then take advantage of lower rates following the expiry of the option period. Purchasing longer tenors will increase the cost considerably and the Bank would need to be concerned over the prospects of a high short term interest rates for the foreseeable future. To reduce the cost of the cap over a longer tenor the Bank may adopt one of many strategies such as buying a further OTM strike, a Forward Cap, a corridor or a Step up cap.

In the case of institutions where the maturities and duration of their assets, such as mortgages, exceed the maturities of their liabilities, usually short term deposits are vulnerable to rises in short term interest rates as the cost of funding will rise without any comparable increase in earnings from its mortgage assetts. The institution may wish to convert the floating rate debt to fixed rate payments using an interest rate swap. However weak credit rating may limit or preclude access to the interest rate swap market for some of these institutions. Caps can be an effective alternative in this scenario, as the risk of a rate rise can be hedged without any consideration of credit risk for the writer once the premium has been received.

Whilst uncommon in Japan caps can have applications in Leveraged Buyouts (LBO's). Institutions involved in any LBO will invariably take on a considerable amount of short term floating rate debt whether it is to fund strategies to defend against, or finance a hostile takeover bid. A successful bid will increase the institutions debt to equity ratio significantly and even a small rise in interest rates could be disastrous. The credit rating of the institution at this stage is unlikely to permit access to the IRS market so the purchase of 2y or 3year caps would hedge the interest rate risk during the period of reorganisation following the LBO.

Volatility provides speculators with an essential benchmark for trading in caps and other interest rate options where most structures are highly customised and the monitoring of risk is extremely complicated.

 4. Corridor

A strategy where the cost of purchasing a cap is offset by the simultaneous sale of another cap with a higher strike. It is possible to offset the entire cost of the cap purchase by increasing the notional amount on the cap sold to match the purchase price. The inherent risk in this strategy is that if short term rates rise through the higher strike the purchaser is no longer protected above this level and will incur considerable risk if the amount of the cap sold is proportionately larger.


 5. Step up cap

In steep yield curve environments the implied forward rates will be much higher than spot rates and the strike for caplets later in the tenor may be deep in the money. The price of a cap, being the sum of the caplets, may prove prohibitively expensive. The step up cap counteracts this by raising the strike of the later caplets to reflect the higher forward rates. This may provide a more attractive combination of risk hedge at a lower price. 

 

After purchasing the Cap, the buyer can make "claims" under the guarantee should Libor be above the level agreed on the Cap on the settlement dates. A Cap is NOT a continuous guarantee, claims can only be made on specified settlement dates. These dates are selected by the purchaser.

Should the buyer never be required to make a claim under the Cap, the option will expire worthless. At settlement a Caplet has a profit profile as follows:

When Libor is below the strike 7.00%, the Caplet has no value. Claims will only be made when Libor is above 7.00%. The break even is therefore the strike plus the premium.

PRICING/VALUE

The Cap price (premium) has two major components:

(a) Intrinsic Value

When the strike of the Cap is LOWER than the Implied Forward rate, the Cap is said to have Intrinsic Value. The Implied Forward is the market expected rate, and therefore if we seek a guarantee of a lower rate, the expected value of the Cap is positive, so it has Intrinsic Value. A Cap that has a strike lower than the implied forward (i.e. has positive Intrinsic Value), is described as IN THE MONEY. A Cap with negative Intrinsic Value, is described as OUT OF THE MONEY A Cap set at the implied forward is described as AT THE MONEY FORWARD. A Cap set at the current Libor level is AT THE MONEY SPOT.
  
Higher Intrinsic 

Value leads to a higher premium.

The relevant Implied Forward is the Swap rate for the period of the Cap or the FRA rate for a Caplet.
  
(b) Time Value

The Cap is a guarantee of a future rate. The implied forward rate will change over time as the market changes its view of future rates. The price of the Cap will therefore depend on the likelihood that the market will change its view. This likelihood of change is measured by volatility. An instrument expected to be volatile between entry and maturity will have a higher price than a low volatility instrument. The volatility used in calculating the price should be the expected future volatility. This is based on the historic volatility.

As time goes by, the volatility will have less and less impact on the price, as there is less time for the market to change its view. Therefore, in a stable market, the passing of time will lead to the Cap FALLING in value. This phenomenon is known as Time Decay. This increases in severity as we get closer to maturity.

REVERSING CAPS

Bought Caps can be sold at any time. The value of the Cap will depend on the same factors above, Intrinsic value and Time Value. The Intrinsic Value is calculated by comparing the strike with the Implied Forward levels . The Time Value will depend on the amount of time left before maturity (less time less value) and the volatility of the underlying instrument (high volatility higher value)

TARGET MARKET

Caps have two major Target Markets:

(a) Borrowers - For borrowers who have loans that reset against Libor, Caps offer an ideal method of providing a maximum cost of interest. Here the Cap is used like an insurance policy. The buyer purchases insurance against Libor rising above a certain level and pays a premium.

(b) Speculators - Investors who believe short term rates will rise can buy a Cap. They will profit when rates are above this level and will limit loss to the cost of the premium.

STRATEGY

The further the strike is set OUT OF THE MONEY, the cheaper the Cap, as the probability of payout is less, therefore the Cap is considered to be more LEVERAGED. As rates rise the Cap will increase in value as it becomes closer to the money.

It is therefore an interesting strategy to buy OUT OF THE MONEY Caps for a small premium which will increase in value dramatically (due to the leverage) as rates rise.

The Cap can then be sold. This is a trading strategy rather than buy and hold strategy.
Sophisticated Investors or Borrowers may like to SELL Caps. This is also known as writing Caps.

In this case the seller is PROVIDING the guarantee and therefore has an unlimited loss potential. The profit from this strategy is limited to the premium earned and will occur when there are no claims against the Cap.

ADVANTAGES

DISADVANTAGES

PRODUCT SUITABILITY

Bought Caps: Simple Defensive

Sold Caps : Simple Aggressive

SUMMARY

Example

Suppose a borrower has a $20 million 2-year revolving credit facility tied to LIBOR. Core outstandings are $12.5 million. The company uses 1 month LIBOR, currently at 6.50%, as its primary borrowing index. For planning purposes, the company has assumed that LIBOR will not rise above 7.50%. 

Without any hedge, the borrower is vulnerable to rising rates.To protect its projections, the company decides to purchase a cap on 1 month LIBOR at 7.50%. The contract will cover a core notional amount of $12.5 million. The company pays an upfront premium for 2 years of protection.

Now, suppose that 1-month LIBOR rises above 7.50% to, say, 8.50%. The company will incur higher interest expense on its borrowings. However, under the Cap Agreement, the company would be reimbursed for the difference between actual LIBOR (8.50%) and the Cap level (7.50%) on the specified notional amount. Regardless of how high LIBOR rises, the borrower is 100% protected above 7.50% on the contracted notional amount for the next 2 years.