CAPS AND FLOORS

Caps are agreements between two parties, whereby one party for an up-front fee
agrees to compensate the other if a designated interest rate (called the reference
rate) exceeds a predetermined level.
Example 1

Caps contract

Suppose a banker grant a loan of Rs 100 Cr at 7% annual interest. Now the banker
has a risk if the interest rate will be increased, the bank has to suffer certain losses
on interest. To hedge such loss, the banker has purchased a caps contract from a
merchant banker. As per the contract if the interest rate will be more than 7.5%, the
merchant banker will pay the interest which will be equal to the increased rate.
This contract will be for 10 years and Rs 100 Cr notional principle. As a
consideration Banker has to pay Rs 10 Lac per annum to the merchant banker.

Case 1 I = 7.25%

Banker has to pay 10 lac

Marchant banker = 000

Case 2 I = 7.75%

Banker has to pay 10 lac

Marchant banker = .25%*10 cr = 2.5 Lac

Net payment Banker has to pay = 7.5 lac

Case 3 I = 9%

Banker has to pay 10 lac

Marchant banker = 1.5%*10 cr = 15 Lac

Net payment Marchant Banker has to pay = 15 – 10 = 5 lac

Floors are agreements between two parties, whereby one party for an up-front fee
agrees to compensate the other if the reference rate is below a predetermined level.

Example2

Floor contract

Suppose a banker received a fixed deposit of Rs 100 Cr at 6% annual interest. Now

the banker has a risk if the interest rate will be reduced, the bank has to suffer
certain losses on interest. To hedge such loss, the banker has purchased a floor
contract from a merchant banker. As per the contract if the interest rate will be less
than 5.5%, the merchant banker will pay the interest which will be equal to the
increased rate. This contract will be for 10 years and Rs 100 Cr notional principle.
As a consideration Banker has to pay Rs 5 Lac per annum to the merchant banker.

Case 1 I = 5.5%

Banker has to pay 5 lac

Marchant banker = 000

Case 2 I = 5%

Banker has to pay 5 lac

Marchant banker = .5%*10 cr = 5 Lac

Net payment = 00000

Case 3 I = 4%

Banker has to pay 5 lac

Marchant banker = 1.5%*10 cr = 15 Lac

Net payment Marchant Banker has to pay = 15 – 5 =10 lac

The party that benefits if the reference rate exceeds (in the case of a cap) or falls
below (in the case of a floor) a predetermined level is called the buyer, and the
party that must potentially make payments is called the seller.

The predetermined interest rate level is called the strike rate.

An interest rate cap specifies that the seller agrees to pay the buyer if the reference
rate exceeds the strike rate. An interest rate floor specifies that the seller agrees to
pay the buyer if the reference rate is below the strike rate.

The terms of an interest rate agreement include:

(1) the reference rate;
(2) the strike rate that sets the cap or floor;
(3) the length of the agreement;
(4) the frequency of reset; and
(5) the notional amount (which determines the size of the payments).

A cap is essentially a strip of options. A borrower with an existing interest rate

liability can protect against a rise in interest rates by purchasing a cap. If rates rise
above the cap, the borrower will be compensated by the cap payout. Conversely, if
rates fall the borrower gains from lower rates.

Interest Rate Collar

An interest rate collar is a relatively low-cost interest rate risk management

strategy that uses derivatives to hedge an investor's exposure to interest rate
fluctuations.

 An interest rate collar uses options contracts to hedge interest rate risk to
protect variable rate borrowers against rising rates or lenders against falling
rates in the case of a reverse collar.
  A collar involves selling a covered call and simultaneously buying a
protective put with the same expiration, establishing a floor and a cap on
interest rates.
 While the collar effectively hedges interest rate risk, it also limits any
potential upside that would have been conferred by a favorable movement in
rates.

A collar is a broad group of options strategies that involve holding the underlying

security and buying a protective put while simultaneously selling a covered
call against the holding. The premium received from writing the call pays for the
purchase of the put option. In addition, the call caps the upside potential for
appreciation of the underlying security's price but protects the hedger from any
adverse movement in the value of the security. A type of collar is the interest rate
collar.

Essentially, an interest rate collar involves the simultaneous purchase of an interest

rate cap and sale of an interest rate floor on the same index for the same maturity
and notional principal amount. An interest rate collar uses interest rate
options contracts to protect a borrower against rising interest rates while also
setting a floor on declining interest rates. An interest rate collar can be an effective
way of hedging interest rate risk associated with holding bonds. With an interest
rate collar, the investor purchases an interest rate ceiling, which is funded by the
premium received from selling an interest rate floor.

Reverse Interest Rate Collar

A reverse interest rate collar protects a lender (e.g., a bank) against declining
interest rates, which would cause a variable rate lender to receive less interest
income if rates decline. It involves the simultaneous purchase (or long) of an
interest rate floor and sale (or short) of an interest rate cap. The premium received
from the short cap partly offsets the premium paid for the long floor. The long
floor receives a payment when the interest rate falls below the floor exercise rate.
The short cap makes payments when the interest rate exceeds the cap exercise rate.