Yield curve – hedging interest rate risk – mini4

1. Introduction

In many instances, a fixed-income portfolio manager may wish to protect himself against adverse interest rate
movements. For example, if he has a long position in a floating rate bond (i.e., a bond whose coupon varies with
the level of some reference rate such as three-month LIBOR), the manager may wish to protect himself against
interest rate decreases that would reduce the coupon income he receives from the bond. In contrast, if the
manager has a floating rate liability, he may want to protect himself against interest rate increases that would
increase his cost of borrowing.

Complex fixed-income securities contain embedded interest rate caps and / or floors, which investors may wish
to hedge by purchasing a cap or floor in the over-the-counter derivatives market.

A cap gives its holder a positive payoff if a reference interest rate exceeds a certain strike rate and no payoff if it
remains below the strike rate. The payoff in this case is equal to the difference between the interest rate and
the strike rate times the notional amount of the agreement.
A floor is just the opposite of a cap. It gives the holder a positive payoff if the interest rate is below the strike
rate and no payoff otherwise. Again, if there is a positive payoff, it is equal to the difference between the
interest rate and the strike rate times the notional principal of the agreement.

2. Interest rate cap and floor

Objective: After this lesson, the learner will be able to describe caps and floors and their payoffs.

Caps and floors provide the payoff at the end of each agreed period for the tenor of the cap / floor agreement.
Usually these periods are matched with a coupon payment frequency when the cap or floor is combined with a
bond position. This payoff structure makes caps / floors equivalent to packages of European interest rates
options, called caplets and floorlets, where each caplet / floorlet expires at the end of a period corresponding to
the cap / floor frequency.

Note that a cap / floor is not simply equal to one interest rate option but a package of independent options, with
the same strike rate, where each option makes a single payoff once it has been exercised and then ceases to
exist. For example, a 3-year cap on 6-month LIBOR contains six caplets. The first caplet expires in 6 months, the
second expires in 12 months, and so on. We are going to examine the relationship between caps / floors and the
corresponding caplets / floorlets more closely in the next section.

As we are dealing with packages of options whose values depend on volatility levels, we will have to estimate
interest rate volatilities again and construct interest rate trees in order to value caps and floors.

In Module 2, we outlined how either historical volatilities or implied volatilities can be used to produce a
volatility estimate. For the purposes of this discussion, we are simply going to take interest rate volatility
estimates as given. This is not because volatility is unimportant. Volatility is a key driver of interest rate option
values, and serious traders and hedgers study volatility patterns extensively in deciding when to buy and sell
interest rate options for hedging or speculative purposes. Our focus here is to look at the drivers of cap and
floor values, rather than a detailed discussion of estimating volatility, which tends to be an experience-based art.

3. Valuation of Caps and Floors

Objective: After this lesson, the learner will be able to describe how caps and floors are valued and how to
calculate their value using binomial trees.

Let’s use a practical example to illustrate how caps and floors are valued. Suppose we have the following
interest rate tree, which we obtained from a term structure model as in previous modules. Binomial interest
rate trees model how short-term interest rates change over time. Given an interest rate as well as an interest
 rate volatility assumption, the binomial model assumes that interest rates can realize one of two possible
states over a given interval of time. By breaking up the time to maturity of a bond into shorter time intervals
(such as one year or half a year), the interest rate behavior over the life of the bond can be modelled using a
binomial interest rate tree.

Based on this interest rate tree, we would like to value a three-year cap with a strike rate of 6 percent, annual
payment frequency, and a $100 notional amount.
The value of the three-year cap is equal to the sum of the values of the corresponding caplets, or European
interest rate options, with one of them expiring at the end of every period. So we have
Value of 3-year cap = Value of 1-year caplet + Value of 2-year caplet + Value of 3-year caplet
The corresponding cap price tree is as follows:

4. Cap value

Objective: After this lesson, the learner will be able to demonstrate the cap value calculations.
To compute the caplet values and the resulting cap values, we can use backward induction again—that is, we
go through the interest rate tree starting from the last period, Year 3 in this case. In Year 3, the value of the
cap is simply equal to the value of the 3-year caplet because the 1-year and 2-year caplets will have expired
by the time we get to Year 3. So, for example, the value of the cap in Year 3 at the top interest rate node can
be calculated as follows:

Note the term (1 + rate) in the denominator. This term is needed because the payoff of the cap isn’t received
until one period later. The settlement payments for caps and floors are in arrears. As a result, the cap payoff
in Year 3 doesn’t take place until the end of Year 3 or 4 years from now. Hence, the payoff has to be discounted
back one period using the appropriate interest rate.
To obtain the values of the cap one period earlier (i.e., Year 2), we need to discount the Year 3 cap values and
add the value of the 2-year caplet at that time to the discounted value. Hence, using the cap values in Year 3
from the tree above, the Year 2 cap value at the highest node is computed as follows:
 So we have

In Year 1 (i.e., one period earlier), the cap value is again obtained by discounting the appropriate cap values
from Year 2 and adding the 1-year caplet value to it. Hence, the cap value at the top node in Year 1 is

5. Current cap value

Objective: After this lesson, the learner will be able to describe current cap value.
The cap value calculation is repeated until we have obtained the current value of the cap. The value of a floor
is computed using exactly the same methodology. The only difference is that the payoff of the floor is
max(strike rate – rate, 0). Hence, it pays off a positive amount if the interest rate is below the strike rate rather
than above.
The price tree for a floor with a 6 percent strike rate and a notional amount of $100 based on the interest rate
tree earlier is as follows:

For example, the floor value at the lowest node in Year 3 is computed as

Again, earlier floor values are obtained by discounting the probability-weighted sum of later floor values and
successively adding the values of the shorter-term floorlets. For example, the floor value at the lowest node
of Year 2 is computed as

6. Caps and Floors Combined with Floating-Rate Bonds

Objective: After this lesson, the learner will be able to describe the combination of caps and floors in the case of
floating-rate bonds.

The value of a structure that combines a floating-rate bond with a cap or floor is simply equal to the value of the
floater plus or minus the value of the cap / floor depending on whether we have a long or a short position in the
cap / floor.
If a cap or floor is combined with a floating-rate bond, the cash flows (coupon payments) from the floater can be
modified as is illustrated in the chart below:
The coupon of a “pure” floating-rate bond is equal to the relevant LIBOR reference rate at the time. So, the
relationship between LIBOR and coupon payments / cash flows is just a straight line. If the floater is combined
with a long position in a floor that has a 5 percent strike rate, the cash flows from this position are shown on the
red line.
Using a 5 percent floor, the minimum coupon rate would be 5 percent, whereas the maximum rate would still be
unlimited. On the contrary, combining a floater with a short position in a cap that has a 5 percent strike rate gives
us the cash flow profile depicted by the green line.
Using a 5 percent cap, the maximum coupon payment / cash flow for this structure would be 5 percent. So if we
hold a floating-rate bond and combine it with a short cap, we would give up the potential to earn a coupon rate
above 5 percent. However, at the same time, we would be able to collect the option premium from selling the
cap.

For the purposes of this analysis, we are assuming a floating-rate bond with no credit or prepayment risk.

7. Valuing Caps / Floors Using the Spreadsheet

Let’s use a practical example to illustrate this relationship with the accompanying spreadsheet.
Note: You may follow the examples below or download the spreadsheet. If you download the
spreadsheet and don't make any changes, the default values will be those described below. If you have
made changes, please re-enter the values corresponding to the example.
a. Select Spot Rates and the values as shown in Figure 1

b. Select Spot Rates and the values as shown in Figure

c. Click the Build Tree button shown in Figure 3.
d. You should get the results shown in Figure 4.

For the moment, ignore the entry labelled “Collar Cost”. We are going to defer the discussion of collars until
the next section. As you can see for the interest rate scenario and strike rates chosen, the cost / value of the
cap is higher than the cost / value of the floor.

The floating rate bond in isolation is worth $100. If we combine the floating rate bond with a long 5 percent
floor position to protect us against decreasing interest rates below 5 percent, we need to add the value of the
floor to the value of the floater to obtain a total value of the structure of $101.57. If we combined a short
position in a cap with a floater, the value of the structure is equal to the value of the floater reduced by the
value of the cap, resulting in a total value of $96.18.

8. Combining Caps and Floors – Collars

Objective: After this lesson, the learner will be able to describe collars and reverse collars.
Market participants with a floating-rate liability often combine caps and floors into a collar by buying an
interest rate cap and selling an interest rate floor with a lower strike rate. The purchase of a cap protects
against rising interest rates, and its purchase price can be wholly or partially offset by the sale of an
interest rate floor. By selling an interest rate floor, however, the borrower gives up any interest rate
savings that could otherwise have been obtained if the reference rate falls below the floor strike rate. In
this case, the seller of the floor has to make a payout to the buyer equal to the difference between the
interest rate and the strike rate.
As a result of the collar, the net interest rate a borrower has to pay is restricted to the range between the
floor and the cap strike rates. Therefore, his interest rate risk is reduced. The following graph shows the
cash outflows of a floating-rate borrower who has a short position in a floating-rate bond or a short floater
combined with a long collar, with strike rates of the cap and floor of 6 percent and 4 percent respectively.
If the cap and floor strike rates are the same, all the interest rate uncertainty has been eliminated. In that
case, the short position in the floating-rate bond plus the collar is equivalent to a short position in a fixed-
rate bond. Or, equivalently, a long position in a floater combined with a short position in a collar (called a
reverse collar) is the same as a long position in a fixed-rate bond. Therefore, the value of the combination
of the floating rate bond and the collar has to equal the corresponding fixed-rate bond value.

To check this relationship, use the same inputs on the Excel spreadsheet as earlier, but set both the cap
and the floor strike rates equal to 6 percent so that they are in line with the fixed-rate bond coupon of $6.
1. Set cap and floor strike to 6% as in Figure 1.
2. Click the Build Tree button shown in Figure 2.
3. As shown in Figure 3, you should see in the last two rows of the results table that the value of the long
floater plus reverse collar combination equals the fixed-rate bond value.

This result is because by selling a floor and buying a cap both with the same strike rate, we have
eliminated any uncertainty with regards to the cash flow / coupon we receive from the structure. In
the example above, the cash flow is always going to be 6 percent regardless of the level of the LIBOR
reference rate. Hence, the structure has exactly the same payoff as a fixed-rate bond with a $6 (or 6
percent) coupon. Therefore, its value has to be the same as well.

A collar is a way of obtaining interest rate protection for a borrower in a cost-efficient way.
 From a bondholder's (or lender’s) perspective, we can obtain interest rate protection using a reverse
collar as shown above. A reverse collar involves combining a short position in a cap with a long position
in a floor. This combination guarantees a minimum coupon rate equal to the strike rate of the floor.
By giving up the potential to earn a coupon rate of more than the cap strike rate, we are able to obtain
interest rate protection in a cost- efficient way. Shorting the cap (partially) finances the floor purchase.

9. Floating-Rate Bonds Containing Embedded Caps and Floors

Objective: After this lesson, the learner will be able to describe floating rates and capped floaters, and
their effect on value structures.
Floating-rate bonds are often structured with a coupon rate that is capped at a certain level or a floor is
placed on their coupon rate. Sometimes a security contains both a cap and a floor.

Capped floaters are equivalent to a combination of a long position in a floater and a short position in a
cap. A capped floater has a lower value than a “pure” floater because its coupon rate is limited to the
cap rate. Therefore, its value is equal to par minus the value of the cap. In other words, an investor in a
capped floater would be able to obtain a “pure” floater by buying back the cap that he has implicitly
shorted. The price discount for the capped floater is compensation for the investor because he is going
to receive below-market yields if the LIBOR reference rate rises above the cap rate. At this point a
floater becomes like a fixed-rate bond because its coupon rate no longer fluctuates.

Similar reasoning applies to floaters that come with a floor-rate protection. For an investor in these
structures, they are equivalent to a floating-rate bond combined with a long floor. Therefore, a floater
with floor-rate protection has a value above par. Its value is equal to the “pure” floater value (i.e., par)
plus the value of the floor. If the LIBOR reference rate falls below the floor, then the floater with floor-
rate protection becomes like a fixed-rate bond because its coupon rate no longer fluctuates.

Some floaters are both capped and have a floor rate. Hence, they are equivalent to a “pure” floater
combined with a reverse collar (or short collar). Therefore, this type of structure only retains floating-
rate bond characteristics as long as the LIBOR reference rate is between the floor and the cap rate,
otherwise the structure’s characteristics will be more similar to a fixed-rate bond.

The values of these different structures are shown in the following graph. Using the interest rate and
volatility scenario from earlier, we shift the spot rate curve up and down in a parallel manner using 50
basis point increments. Under each rate shift scenario, we record the values of a “pure” floating-rate
bond, a fixed-rate bond, as well as a capped floater with a 6 percent cap, a floater with a 5 percent floor,
and a floater with both a cap and a floor.

The graph shows that as interest rates decline, the capped floater’s value is very similar to the floating-
rate bond’s value because the cap is out of the money. As interest rates increase, the capped floater
becomes like a fixed-rate bond and, therefore, has a similar value. The floater with a floor becomes very
similar to a “pure” floater when interest rates increase and, therefore, has a similar value. As interest
 rates decrease, the floater becomes more similar to a fixed-rate bond and its value approaches the
fixed-rate bond value.

10. Zero-Cost Collars

Objective: After this lesson, the learner will be able to show how zero-cost collars are obtained using
the spreadsheet.
A collar that is often of particular interest is the so-called zero-cost collar. For a zero-cost collar, the cap
and floor strike rates are chosen in such a way that the values of the cap and the floor are equal.
Therefore, by selling the floor and buying the cap, a floating-rate borrower is able to obtain some
protection against interest rate increases at zero cost.

Numerical procedures can be used to solve either for the floor strike rate, given a desired cap strike rate,
that results in a zero-cost collar or for the cap strike rate, given a desired floor strike rate, that produces
a zero-cost collar.
Let’s take a look at a practical example. Use the earlier example again in which we had the following
inputs:

11. Analysis of Zero-Cost Collar Example

Objective: After this lesson, the learner will be able to analyze the zero-cost collar using the
spreadsheet.
The cost of the cap exceeds the cost of the floor. Therefore, the cost of the collar is positive. To produce
a zero-cost collar, we could either solve for a floor strike rate that, for a cap strike rate of 6 percent,
makes the collar costless or we could solve for the cap strike rate that, for a floor strike rate of 5
percent, makes the collar costless.
Let’s try both approaches. First, leave the cap strike rate at 6 percent and solve for the floor strike rate

that produces a zero-cost collar by pressing the button …

You should see the following result …

Now, reset the floor strike rate to 5.00% and then press the button …
You should see the following output …
Hence, if you wanted protection against rising interest rates exceeding a strike rate of 6.00 percent, you
would be able to obtain this type of protection at no cost if you combine your cap purchase with selling
a floor with a strike rate of 5.66 percent. Therefore, the price you pay for the protection against rising
rates is offset by giving up the lower borrowing costs that would result if interest rates fell below 5.66
percent.

Alternatively, if you wanted to benefit from potential interest rate decreases down to a level of 5.00
percent, you would have to accept interest rate increases up to 7.05 percent if you wanted to obtain
 costless protection. Better interest rate protection can only be obtained by paying a positive amount for
the collar or by giving up more interest rate savings if interest rates decline.
12. Caps and Floors vs. Options on Bonds
Objective: After this lesson, the learner will be able to compare options on bonds with caps and floors.
Caps and floors, as packages of interest rate options, are very similar to options on bonds. Both types of
options are influenced by interest rates. The important difference between these two option types is,
however, that the value of caps and floors depends directly on the level of the interest rate, whereas the
value of options on bonds depends on the bond price that, in turn, is affected by interest rates. As a
result, the values of each type of option move in different directions as interest rates change.

This can be summarized as follows:

Therefore, buying a cap is equivalent to buying a package of puts on a bond, and buying a floor is
equivalent to buying a package of calls on a bond.
13. Summary
Fixed-income market participants are able to protect themselves against adverse interest rate moves by
using caps and floors. Caps pay out a positive amount if the reference interest rate exceeds their strike
rate, and floors pay out a positive amount if the reference rate falls below their strike rate. Combined
with floating-rate bond positions, they provide interest rate protection. However, they can also be
combined with a fixed-rate bond to allow the holder to benefit from rising interest rates or the savings
provided for a borrower from falling interest rates.

To provide interest rate protection at a lower cost, caps and floors are often combined in a collar or
reverse collar in which shorting one component (cap or floor) partially or fully offsets the cost of the
component (cap or floor) that is purchased.

As we have seen, caps and floors, as options on interest rates, are equivalent to packages of options on
bonds, which are options on bond prices that are, in turn, affected by interest rates.

14. Questions:
a. Suppose the interest rate volatility increases. How will this increase affect the value of a cap and a floor?
Since caps and floors are packages of interest rate options which provide a limited downside to the
option holder and almost unlimited upside potential, their value always benefits from increasing
volatility as the chance of a large payoff that the option holder receives is increased but his downside
remains limited.
b. Again, suppose the interest rate volatility increases. How will this increase affect the cost of a collar that
was a zero-cost collar in the original volatility environment? The value of the collar … A zero-cost collar is
a combination of a short position in a floor and a long position in a cap that is self-financing, i.e. the
value of the floor sold short is equal to the value of the cap purchased. We know from Problem 1 that
the value / cost of a cap and a floor increases if interest rate volatility increases. However, the relative
magnitude of the increase depends on the characteristics of the cap and the floor as well as on the
interest rate environment.
c. Suppose you have a long position in a fixed rate bond with a 6% coupon and ten years remaining to
maturity. You would like to use a cap and/or a floor in order to convert this position to a long position in
 a floating rate bond. What would be the cost of this under the following scenario for a $100 notional
amount?

Making these inputs in the accompanying spreadsheet and pressing the “Build Tree” button yields a
floating-rate bond value of $100 and a fixed-rate bond value of $101.46. Therefore, the short floor
position produces more option premium than the long cap position costs, and the collar has a negative
rather than a positive cost. Whether the collar produces income or costs money depends in part on the
relationship between the coupon rate and interest rates.
In order to convert the long position in the fixed rate bond to a long position in a floating rate bond, a
collar has to be purchased with both the cap and the floor strike rate equal to the fixed rate bond
coupon rate, in this case 6%. Once you make these inputs on the accompanying spreadsheet and press
the “Build Tree” button, the results table shows a cost for the collar of –$1.46, i.e. you would get paid by
entering this agreement. This is because the floating rate bond has a lower value than the fixed rate
bond which can also be seen from the results table. The floating rate bond value is $100 and the fixed
rate bond value is $101.46, a difference of –$1.46.

d. Suppose you are a borrower paying a fixed borrowing rate of 6% on a notional amount of $100. Since
you expect interest rates to decrease, you would like to benefit from the expected decrease by lowering
your borrowing costs. Which type of transaction (and at which cost) would be able to achieve your
objective under the same scenario as in Problem 3?
A long position in a floor gives you a positive payoff if interest rates fall below its strike rate. Therefore,
buying a floor allows you to benefit from falling interest rates. Under the scenario from Problem 3, we
obtain a floor cost of $5.27 using the accompanying Excel spreadsheet.
Buying a cap gives its holder a positive payoff if interest rates rise above its strike rate. Therefore, buying
a cap does not provide a benefit to the borrower if interest rates fall.
Buying the collar involves purchasing a cap to protect against rising interest rates and selling a floor. By
selling a floor (rather than buying a floor), the borrower gives up any interest rate savings associated
with a fall in interest rates below the floor strike rate.
e. Using the same inputs as in Problem 3 above, a floating rate borrower would like to obtain interest rate
protection on a notional amount of $100. He would like to avoid paying a borrowing rate of more than
6%. How could he achieve his objective at zero cost?