Caps and floors are types of interest rate derivatives that can be used to hedge against interest rate fluctuations. They are similar to options, but they have fixed strike prices and notional values.
A cap is a contract that gives the buyer the right to receive a payment at the end of each period if the interest rate exceeds the strike price. For example, if you buy a cap on the 6-month LIBOR rate with a strike price of 2.5%, you will receive a payment for each month that the LIBOR rate is above 2.5%. The payment is calculated as follows:
Payment = Max [0; Notional × (Index rate – Cap strike rate) × (Days in settlement period / 360)]
A floor is a contract that gives the buyer the right to receive a payment at the end of each period if the interest rate falls below the strike price. For example, if you buy a floor on the 6-month LIBOR rate with a strike price of 2%, you will receive a payment for each month that the LIBOR rate is below 2%. The payment is calculated as follows:
Payment = Max [0; Notional × (Floor strike rate – Index rate) × (Days in settlement period / 360)]
The buyer pays a premium to purchase the cap or floor, which is also known as the cost of protection. The buyer faces credit risk, meaning that if the interest rate moves against them, they may not be able to make their payments.
Caps and floors can be combined into an interest rate collar, which creates an interest rate range for the buyer. An interest rate collar consists of buying a cap and selling a floor with different strike prices and notional values. For example, suppose you buy a cap on the 6-month LIBOR rate with a strike price of 2% and notional value of $1 million, and sell a floor on the same index with a strike price of 1% and notional value of $1 million. You pay $100,000 as premium for this collar.
Basic Theory:
Options play a crucial role in finance, providing investors with versatile tools to manage risk and speculate on future market movements. Caps and floors are two popular option strategies used to mitigate interest rate risk.
- Cap: A cap is a series of European call options used to limit the interest rate on a floating-rate loan. If interest rates rise above the cap rate, the cap pays the difference to the holder.
- Floor: Conversely, a floor is a series of European put options designed to protect against falling interest rates. If rates fall below the floor rate, the floor pays the difference to the holder.
Procedures:
The process of implementing caps and floors involves several steps:
- Determine the Reference Rate: Identify the reference interest rate that the cap or floor will be based on (e.g., LIBOR).
- Select the Cap/Floor Rate: Choose the cap rate (maximum interest rate) or floor rate (minimum interest rate) that aligns with your risk management strategy.
- Calculate the Option Premium: Use the Black-Scholes or other option pricing models to determine the premium for the cap or floor options. Excel provides functions like
BLACKSCHOLESfor this purpose. - Construct the Cap/Floor: Once the premium is calculated, structure the cap or floor by buying/selling the appropriate number of options.
- Monitor and Adjust: Regularly monitor interest rates and adjust the position if necessary to maintain the desired risk exposure.
Explanation with Excel:
Let’s consider a scenario where a company has a variable-rate loan linked to LIBOR. The company is concerned about rising interest rates and decides to implement a cap with the following details:
- Notional Amount: $10,000,000
- Cap Rate: 3%
- Maturity: 1 year
- Volatility: 15%
- Current LIBOR: 2%
Calculation:
-
- Use the Black-Scholes formula in Excel to calculate the premium for a European call option:
=BLACKSCHOLES("call", 2%, 3%, 1, 2%, 0.15)
The result is the premium per unit. Multiply by the notional amount to get the total premium.
- Construct the cap by buying call options with the determined premium.
- If interest rates rise above 3%, the cap will compensate the company for the difference.
Other Approaches:
- Binomial Model: Instead of Black-Scholes, use a binomial model to value the options.
- Alternative Derivatives: Explore other interest rate derivatives, such as interest rate swaps, to achieve a similar risk management goal.
