# Interest Rate Caps / Floors / Collars

INTEREST RATE OPTIONS • • • • • Cap: a call option on an interest rate At each settlement date, check whether index rate is greater than strike rate If not, cap purchaser does not receive cash flows If so, purchaser receives from seller: [ (index rate - strike rate) x (days in settlement period / 360) x [notional amount ]

Example: \$20,000,000 two-year quarterly interest rate cap on 3-month LIBOR with a strike rate of 8% Cost: 150 basis points. • • Up-front premium = 0.015 x \$20M = \$300,000 If 3-month LIBOR = 9%, seller pays (.09-.08) x 90/360 x \$20M = \$50,000 (for that quarter)

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Floor: a put option on an interest rate At each settlement date, check whether index rate is greater than strike rate If so, floor purchaser does not receive cash flows If not, purchaser receives from seller: [ (strike rate - index rate) x (days in settlement period / 360) x notional amount ]

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Collar: simultaneously buying a cap and selling a floor Purchase a cap to hedge floating-rate liabilities Sell a floor at a lower strike rate Sale of floor helps finance purchase of cap Net result: Interest expense will be limited on both ends -- will float between the cap and floor strike rates Can achieve zero-premium collar

Q. As the assistant treasurer of a large corporation, your job is to look for ways your company can lock in its cost of borrowing in the financial markets. The date is January 2. Your firm is taking out a loan of \$25,000,000, with interest to be paid on January 2, April 2, July 2 and October 2. Your will pay the LIBOR in effect at the beginning of the interest payment period. The current LIBOR is 10 percent. You recommend that the firm buy an interest rate cap with a strike of 10 percent and a cap for an up-front payment of \$70,000. Determine the cash flows with and without over the life of this loan if LIBOR turns out to be 9.75 percent on April 2, 12.375 percent on July 2, and 11.50 percent on October 2. The payoff is based on the exact number o days and a 360-day year Solution: Calculation of Net Cash Flow with and without Cap Date Days in period 90 91 92 92 LIBOR (%) Interest Due Cap Payment Principal Repayment Net Cash Flow with Cap \$24,930,000 -\$625,000 -\$616,146 -\$638,889 -\$25,638,889 Net Cash Flow without Cap \$25,000,000 -\$625,000 -\$616,146 -\$790,625 -\$25,734,722

January 2 April 2 July 2 October 2 January 2

10.000 9.750 12.375 11.500

\$625,000 \$616,146 \$790,625 \$734,722

-\$70,000 \$151,736 \$95,833 \$25,000,000

Q. You are a fund’s manager for a large bank. On December 16, your bank lends a corporation \$ 15,000,000, with interest payments to be made on March 16, June 16, and September 15. The amount of interest will be determined by LIBOR at the beginning of the interest payment period. On December LIBOR is 8 percent. Your forecast is for declining interest rates, so you anticipate lower loan interest revenues. You decide to buy an interest rate floor with a strike set an 8 percent and a floor for an upfront payment of \$30,000. Determine the cash flows with and without over the life of this loan if LIBOR turns out to be 8.25 percent on March 16, 7.125 percent on June 16, and 6.00 percent on September 16. The payoff is based on the exact number of days and a 360-day year.

Solution: Calculation of Net Cash Flow with and without Floor Date Days in period 90 92 91 92 LIBOR (%) Interest Due Floor Payment \$30,000 \$33,177 \$76,667 Principal Repayment \$15,000,000 Net Cash Flow with Floor \$15,030,000 \$300,000 \$316,250 \$303,333 \$15,306,667 Net Cash Flow without Floor \$15,000,000 \$300,000 \$316,250 \$270,156 \$15,230,000

December 16 March 16 June 16 September 15 December 16

8.000 8.250 7.125 6.000

\$300,000 \$316,250 \$270,156 \$230,000