CAPS, FLOORS & SWAPTIONS

A borrower can hedge the risk arising out of a loan on floating rate of interest, through swaps. He can do so by entering in to a swap and turn his liability into a fixed rate liability. Now, he is not harmed financially, if the interest rates go up. But, what happens when the interest rates go down ? The potential benefit to a borrower with a decline in the interest rates is eliminated because of the swap. Hence, such swaps may be harmful also. Similarly, a lender can protect himself from losses arising out of declining interest rates by getting in to a swap agreement. However, this also removes the chances of gain, with the rise in the interest rates.

CAPS, FLOORS & SWAPTIONS

In this world there is nothing called a free lunch. This means that the borrower who wants a cap will have to pay for it, in some form. This could be an upfront payment or it could also be a higher rate of interest.( say 0.5% more than the floating rate benchmark). Similarly, the floating rate lender might want an arrangement whereby he receives a floating rate subject to a FLOOR say 3%. This means that even if the interest rates fall to say 2% or 1%, he receives at least 3% and if the interest rate rises he receives the higher rate.

CAPS, FLOORS & SWAPTIONS

Both the floating rate borrower and the floating rate lender are keen to LIMIT their downside( very high rates and very low rates respectively) while retaining some upside. Instruments like Interest rate caps and Interest rate floors are designed to achieve the above. A floating rate borrower would want an arrangement where he pays floating rate subject to a CAP of say 10%. This means that even if the interest rates rises to 15% or 20%, he pays only the cap rate i.e., 10%. If the interest rate falls, he pays on the lower rate.

CAPS, FLOORS & SWAPTIONS

The lender desiring a FLOOR will have to pay something, which may be an upfront payment or agreeing to an interest rate lower than the benchmark.

Many floating rate bonds have inbuilt caps and floors within the bonds. However, it is also possible to buy the cap or floor separately from the market. A borrower can issue a floating rate bond without any caps or floors and then go to a bank an buy a cap.

CAPS, FLOORS & SWAPTIONS

If he desires to cap his interest cost at say 10%, he would enter into a contract with the bank. Under the contract, whenever the floating rate exceeds 10%, the bank pays him the difference. If the floating rate is less than the cap the bank pays nothing. The cap in this case is said to have a STRIKE of 10%. Obviously, the bank charges something as it is selling the cap. Similarly, the lender can go to a bank and buy a floor, say with a STRIKE of 3%.

CAPS, FLOORS & SWAPTIONS

It may also so happen that the borrower, while buying a cap from the bank might sell a floor to the same bank or any other bank. This is done to recoup, whole or part of the cost of the cap. Similarly, a lender buying a floor may even sell a cap to recoup the cost of the floor.

Company A issues 7 years bonds at floating rate of interest. This means, as the interest rates go up the companys liability increases. To safeguard, the company buys a CAP from ICICI bank with a strike rate of 9% at a cost of 10000000/-. The company also sells a floor to the bank at a strike rate of 4%, (at a price of 75 lacs)anticipating that the interest rates will not go below 4% in the next 7 years. In the first quarter the prevailing interest rate (MIBOR) stands at 11%. The bank pays to company A 2% of the bond value. (11-9).

In the next quarter, the MIBOR comes down to 8%. The bank pays nothing. The third quarter shows a MIBOR of 4% and the bank pays nothing. Now, if the MIBOR goes below 3% the company will have to pay to the bank the differential amount. Say the MIBOR is 2%. The payment by the company to the bank would be (3-2) 1% of the total bond value. The company has recouped 75 lacs of its cost of buying a cap.