Interest Rate Derivatives Caps, Floors, Collars & FRAs

Hedging the Interest Rate

Hedging a raise in Interest Rate (for borrowing decisions) or short term hedging.

Hedging a fall in Interest Rate ( for investing decisions) or long term hedging.

Interest rate Caps

Over-the-counter contract Considering a floating rate, Interest rate is reset periodically to LIBOR. The time between resets tenor An interest rate cap is designed to provide insurance against the rate of interest on the floating rate note rising above a certain level. The level is known as CAP RATE. An interest rate cap is a portfolio of Call options on interest rate.

Interest rate Caps-Example

Principal Amount - $10 Million Tenor 3 months Life of the cap 3 Years Cap rate - 4%(payments made quarterly) Cap provides hedge against the floating rate rising above 4%. The 3-m LIBOR is 5%, 0.25*0.05*$10,000,000= $1,25,000 Cap provides a pay-off of $25,000.

Interest rate Floors

An interest rate floor is designed to provide insurance against the rate of interest on the floating rate note falls below a certain rate. The level is known as FLOOR RATE. An interest rate Floor is a portfolio of PUT options on Interest rates.

Interest rate Collars

A Collar is a strategy designed to guarantee that the interest rate on the underlying floating rate always remain between two levels.

Combination of a Cap & Floor.

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PROBLEM

Forward Rate Agreement - FRAs

Notionally an agreement between two parties One of them(seller of FRA) contracts to lend the other( buyer of FRA) a certain amount of funds, in particular currency, for a specified period starting at a specified future rate, at an interest rate fixed at the time of agreement.

 Notionally Underlying principal exchange doesnt happen, but only interest rate is locked in. USD 6/9 months: 7.20-7.30% p.a. The bank willing to accept 3-month US Dollar deposit, starting 6 months from now, maturing 9 months from now at an interest rate of 7.20%- Bid rate.

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