Interest Rate Caps And Floors Example

Options on caps are called captions.

Interest rate caps and floors example.

It is simply a series of call options on a floating interest rate index. Caps are better than swaps interest rate swaps and interest rate caps properly structured save hundreds of thousands in interest expense. Some commercial banks and investment banks now write options on interest rate caps and floors for customers. Interest rate caps and floors are option like contracts which are customized and negotiated by two parties.

An interest rate floor is similar to an interest rate cap agreement. Interest rate caps and floors. An interest rate cap establishes a ceiling on interest payments. A borrower with an existing interest rate liability can protect against a rise in interest rates by purchasing a cap.

At time 0 the. Interest rate floors are utilized in derivative. For example a borrower who is paying the libor rate on a loan can protect himself against a rise in rates by buying a cap at 2 5. Options on floors are called flotions.

Cap payments time 0 time 0 5 time 1 5 54 6 004 0 4 721 6 915 0 127 5 437 4 275 consider a 100 notional of 1 5 year semi annual cap with strike rate k 5 75 indexed to the 6 month rate. A cap is essentially a strip of options. The example below illustrates one of many success stories in helping clients effectively manage interest rate risk using interest rate swaps and interest rate caps. Caps and floors are based on interest rates and have multiple settlement dates a single data cap is a caplet and a single date floor is a floorlet.

An interest rate cap or ceiling is an agreement between the seller or provider of the cap and a borrower to limit the borrower s floating interest rate to a specified level for a specified period of time. For example as a borrower with current market rates at 6 you would pay more for an interest rate collar with a 4 floor and a 7 cap than a collar with a 5 floor and a 8 5 cap. An interest rate floor is an agreed upon rate in the lower range of rates associated with a floating rate loan product. Hedging loans with libor floors.

Caps and floors can be used to hedgeagainst interest rate fluctuations. The premium for an interest rate collar also depends on the rollover frequency and how you make your premium payments.