Interest Rate Cap

An interest rate cap places a ceiling (cap strike) on a floating rate of interest on a specified notional principal amount for a specific term. The buyer of the cap uses the cap contract to limit his maximum interest rate. If the buyer's floating rate rises above the cap strike, the cap contract provides for payments from the seller to the buyer of the cap for the difference between the floating rate and the cap strike. If the floating rate remains below the cap strike, no payments are required. The cap buyer is required to pay an up front fee for the cap.
The cap premium charged by the seller depends upon the market's assessment of the probability that rates will move through the cap strike over the time horizon of the deal. If the yield curve is upward sloping, a shorter term (two years vs. five years) and/or a higher strike (7.0% vs. 6.0%) will result in a lower cap premium. Normally, the cap premium for the entire life of the cap is paid two days after the trade date. The cap premium takes the form of an up front charge that is usually expressed in basis points as a percentage of the notional principal amount.
Any period that the cap is in the money (floating rate > cap strike), the cap buyer's effective rate is equal to the cap strike plus the amortized cap premium in basis points. Otherwise, the effective rate equals the floating rate plus the amortized cap premium. The calculation or determination of the floating rate depends upon its underlying index (i.e., LIBOR, Commercial Paper, Prime, etc.) and the specific terms of the transaction (discrete setting or average). For example, LIBOR caps are normally discrete setting (LIBOR set at the beginning of the period), and Commercial Paper and Prime caps are normally averaged (Set at the end of the period based on the average of the underlying index during the period.)
Credit exposure in an interest rate cap transaction is one-way. The buyer of the cap is exposed to the seller for potential payments under the cap over the life of the transaction. The buyer should be cognizant of the creditworthiness of its counterparty. At the Bank formal credit approval is required for the Bank to purchase a cap.
EXAMPLES OF PAYMENT FLOWS If cap strike > floating rate, there will be no payment on the cap. However, the amortized premium increases the effective interest rate paid by the buyer of the cap. If floating rate > cap strike on the reset date, the seller of cap will pay the buyer at settlement: notional principal x (floating rate - cap strike) x actual days/360 The cap buyer’s effective interest rate with a cap is equal to the lower of the floating rate or the strike rate plus, in each case, the amortized cost of the cap premium.
TYPICAL CHARACTERISTICS

Start date: Spot (the first interest fixing after the trade date) or forward
Floating Rate Indexes: All Major Fixed Income Indexes

Term: Up to 10 years
Structures: Bullet, Amortizing or Accreting
Strike(s): Constant or at varying Levels
Reset Frequency: Semi-annually, Quarterly, Monthly, or Daily
Setting: Discreet or Average

TYPICAL CAP APPLICATION
Liability Management

Situation 1: A borrower with all floating rate debt (LIBOR + Spread) is concerned about rising interest rates and wants next year to edge a portion of the debt for three years. The borrower has projected LIBOR at 6% in 2001, 7% in 2002 and 8% in 2003.
Solution: The company purchases a step-up strike interest rate cap that places a ceiling on LIBOR at 6% in 2001, 7% in 2002 and 8% in 2003. The cap limits the borrower's interest rate risk to the projected levels through 1999, and if LIBOR remains below the strike levels the borrower benefits from the lower rates.

Situation 2: A borrower has a subordinated debt issue that matures in six months and will be replaced with bank debt. The subordinated debt has a rate of 10% and the borrower does not want the interest rate on the bank debt to exceed 10% for the first three years after the subordinated debt matures. The bank debt will be priced at LIBOR + 2.5%.
Solution: The borrower purchases a six-month forward starting three year interest rate cap at 7.5%. The cap limits the borrower's interest rate expense to a maximum of 10% (7.5% + 2.5%), but allows the borrower to benefit if LIBOR stays below 7.5%.

Situation 3: A corporation issues ten-year fixed rate debt, but wants some exposure to short-term interest rates for the first three years. The company is uncomfortable with a swap at current rate levels.
Solution: The corporation sells an interest rate cap at a strike level above the current three-year swap rate. The corporation collects the cap premium and takes a limited amount of exposure to short-term interest rates.

TYPICAL CAP APPLICATION
Asset Management

Situation 1: An investor holds a floating rate note (LIBOR + .20%) with three years remaining to maturity The investor feels shortterm rates are likely to remain unchanged or decline and wants to enhance the return on the floating rate note.
Solution: The investor sells an interest rate cap at an out of the money strike level. The investor collects the premium that enhances the yield on the floating rate note at current or slightly rising interest rate levels. However, if short-term interest rates rise through the cap level, the investor's yield will not increase.