Interest Rate Caps / Floors / Collars

Rate Limiting Tools: Interest Rate Caps, Floors and Collars Caps and Floors are essential tools in managing floating rate liabilities while minimizing hedging and opportunity costs. They protect against adverse rates risk, while allowing gains from favourable rate movements. Caps and floors are forms of option contracts, conferring potential benefits to the purchaser and potential obligations on the seller. When purchasing a cap or floor, the buyer pays a premiumtypically up-front. The premium amount depends on the specified cap or floor rate and time period covered, which may range from a few months to several years. Benefits of Caps, Floors and Collars Caps and Floors greatly enhance a treasurer's flexibility in managing financial assets and liabilities. Used together or in combination with other hedging instruments, Caps and Floors are efficient tools for reconfiguring a company's financial risk profile. Caps and Floors are used to: Hedge floating-rate liabilities Reduce borrowing costs Increase investment returns Create synthetic investments Neutralize options embedded in assets or liabilities Interest Rate Caps A cap creates a ceiling on floating rate interest costs. When market rates move above the cap rate, the seller pays the purchaser the difference. A company borrowing on a floating rate basis when 3 month LIBOR (London Interbank Offered Rate) is 6% might purchase a 7% cap, for example, to protect against a rate rise above that level. If rates subsequently rise to 9%, the company receives a 2% cap payment to compensate for the rise in market rates. The cap ensures that the borrower's interest rate costs will never exceed the cap rate. Interest Rate Floors A floor is the mirror image of a cap. When market rates fall below the floor rate, the seller pays the difference. A 6% floor triggers a payment to the purchaser whenever market rates drop below 6%. Asset managers buy floors to guarantee a minimum return on floating rate assets. They sell floors to generate incrementally higher returns. Debt managers buy floors to protect against opportunity losses on fixed rate debt when rates fall. They may sell floors as a component of a hedge strategy involving other derivative instruments. Combining Caps and Floors to Create Collars A Collar is created by purchasing a cap or floor and selling the other. The premium due for the cap (floor) is partially offset by the premium received for the floor (cap), making the collar an effective way to hedge rate risk at low cost. In return the hedger gives up the potential benefit of favourable rate movements outside the band defined by the collar. A borrower who purchases an 8% cap and sells a 6% floor guarantees a 6-8% base rate on a floating rate loan. An investor in floating rate CD's might do exactly the opposite, buying a 6% floor and financing it with the sale of an 8% cap. A costless collar is created when the cap and floor levels are set so that the premiums exactly offset each other. Caps and Floors are a simple but very effective way to control risk and manage hedge costs. The option characteristics of caps and floors offer unique opportunities to minimize borrowing costs or achieve higher investment returns.

INTEREST RATE OPTIONS Cap: a call option on an interest rate At each settlement date, check whether index rate is greater than strike rate If not, cap purchaser does not receive cash flows If so, purchaser receives from seller: [ (index rate - strike rate) x (days in settlement period / 360) x [notional amount ]

Example: $20,000,000 two-year quarterly interest rate cap on 3-month LIBOR with a strike rate of 8% Cost: 150 basis points. Up-front premium = 0.015 x $20M = $300,000 If 3-month LIBOR = 9%, seller pays (.09-.08) x 90/360 x $20M = $50,000 (for that quarter)

Floor: a put option on an interest rate At each settlement date, check whether index rate is greater than strike rate If so, floor purchaser does not receive cash flows If not, purchaser receives from seller: [ (strike rate - index rate) x (days in settlement period / 360) x notional amount ]

Collar: simultaneously buying a cap and selling a floor Purchase a cap to hedge floating-rate liabilities Sell a floor at a lower strike rate Sale of floor helps finance purchase of cap Net result: Interest expense will be limited on both ends -- will float between the cap and floor strike rates Can achieve zero-premium collar

Q. As the assistant treasurer of a large corporation, your job is to look for ways your company can lock in its cost of borrowing in the financial markets. The date is January 2. Your firm is taking out a loan of $25,000,000, with interest to be paid on January 2, April 2, July 2 and October 2. Your will pay the LIBOR in effect at the beginning of the interest payment period. The current LIBOR is 10 percent. You recommend that the firm buy an interest rate cap with a strike of 10 percent and a cap for an up-front payment of $70,000. Determine the cash flows with and without over the life of this loan if LIBOR turns out to be 9.75 percent on April 2, 12.375 percent on July 2, and 11.50 percent on October 2. The payoff is based on the exact number o days and a 360-day year Solution: Calculation of Net Cash Flow with and without Cap Date Days in period 90 91 92 92 LIBOR (%) Interest Due Cap Payment Principal Repayment Net Cash Flow with Cap $24,930,000 -$625,000 -$616,146 -$638,889 -$25,638,889 Net Cash Flow without Cap $25,000,000 -$625,000 -$616,146 -$790,625 -$25,734,722

January 2 April 2 July 2 October 2 January 2

10.000 9.750 12.375 11.500

$625,000 $616,146 $790,625 $734,722

-$70,000 $151,736 $95,833 $25,000,000

Q. You are a funds manager for a large bank. On December 16, your bank lends a corporation $ 15,000,000, with interest payments to be made on March 16, June 16, and September 15. The amount of interest will be determined by LIBOR at the beginning of the interest payment period. On December LIBOR is 8 percent. Your forecast is for declining interest rates, so you anticipate lower loan interest revenues. You decide to buy an interest rate floor with a strike set an 8 percent and a floor for an upfront payment of $30,000. Determine the cash flows with and without over the life of this loan if LIBOR turns out to be 8.25 percent on March 16, 7.125 percent on June 16, and 6.00 percent on September 16. The payoff is based on the exact number of days and a 360-day year.

Solution: Calculation of Net Cash Flow with and without Floor Date Days in period 90 92 91 92 LIBOR (%) Interest Due Floor Payment $30,000 $33,177 $76,667 Principal Repayment $15,000,000 Net Cash Flow with Floor $15,030,000 $300,000 $316,250 $303,333 $15,306,667 Net Cash Flow without Floor $15,000,000 $300,000 $316,250 $270,156 $15,230,000

December 16 March 16 June 16 September 15 December 16

8.000 8.250 7.125 6.000

$300,000 $316,250 $270,156 $230,000