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What is a Cap?

Thursday, January 12, 2012

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An interest-rate cap is an OTC derivative that protects the holder from rises in short-term interest rates by making a payment to the holder when an underlying interest rate (the "index" or "reference" interest rate) exceeds a specified strike rate (the "cap rate"). Caps are purchased for a premium and typically have expirations between 1 and 7 years. They may make payments to the holder on a monthly, quarterly or semiannual basis, with the period generally set equal to the maturity of the index interest rate.

Each period, the payment is determined by comparing the current level of the index interest rate with the cap rate. If the index rate exceeds the cap rate, the payment is based upon the difference between the two rates, the length of the period, and the contract's notional amount. Otherwise, no payment is made for that period cap is a string of single caplets and therefore a string of call options on interest rates*.

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A cap has an insurance characteristic through the payment of the premium while sustaining the chance to benefit from constant or even falling interest rates. The benefit is the greatest, as with buying any option, when interest rates are going down and no compensation payments will be made (assumption). Caps are usually quoted with an up-front premium.

* - Source Riskglossary

Valuation of the cap

Caps and floors can be bought and sold like any other financial instrument. If a client has purchased a cap or a floor and wishes to unwind the transaction, they would simply sell it back to the bank at the prevailing market price. The market price of a cap or floor is af unction of several factors including volatility, the proximity of the cap/floor strike level to the underlying swap rate, the notional and time to maturity. As each variable changes, the value of the greater-than or equal to zero.

The premium will depend upon how close to current forward/swap rates the cap is being set (don’t forget the interest rate volatility in the respective period). Volatility is lower at the long end of the curve compared to the short end (highest in 3y maturity bucket). At normal (steep) yield curve, caps are significantly more expensive than in a flat or even inverse yield curve environment.

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FactorIncreaseDecrease
VolatilityValue of option increasesValue of option decreases
Underlying Swap rateCap value increases Floor value decreasesCap value decreases Floor value increases
NotionalValue of the option increasesValue of the option decreases
Time to maturity/expiryValue of the option increasesValue of the option decreases

The slope of the yield curve and hedging strategies

Steep yield curve = steep forward curve = high premiums = relatively cheap floor premiums (A) Flat yield curve = flat forward curve = relatively cheap caps = relatively high floor premiums (B) Inverse yield curve = inverse forward curve = cheap caps = high floor premiums (C)

fig6.png

CapCap buyerCap seller
FeatureLeads to compensation payments when the upper limit is being exceededKeeps the premium when upper limit is not being exceeded
IntentionExpectation to participate at low money market interest rates and to hedge against increasing interestrates.Interest cost reduction or yield enhancement
RiskLimited to paid option premiumReturn never greater than cap premium

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