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and Collars

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Interest Rate Caps, Floors and Collars

An interest rate cap is a contract where if interest rates exceed a certain strike rate, for an agreed upon notional amount, the buyer will receive interest for the interest differential over the strike rate for the given conversion period. Consider it insurance protection against rising interest rates. Caps are mainly used by borrowers to protect them from raising interest rates.

The critical elements of an interest rate cap are listed below:

·        Strike Rate – The trigger rate where payment is to the purchaser if market rates exceed it. The rate can be a set percentage, or an underlying reference index rate (usually LIBOR) or a reference rate plus a spread. It’s the ceiling exposure if rates increase.

·        Notional Amount – The underlying principle amount. The notional amount can also have an amortization schedule attached.

·        Start Date – The commencement date

·        Settlement Date  - Payment date

·        Interest Calculation – There are various acceptable interest calculations, such as the actual number of days / 360 or 365.

Example: Lenders often rely on interest rates caps to protect their margins from unexpected interest rate increases. These companies originate many fixed rate term loans or leases. Their new business volume is usually initially funded by floating rate revolving debt, and then securitized at a later date. They always have a certain amount of volume debt sitting in their revolver. Management, however, often chooses not to absorb the full cost of swaps, but is willing to pay the “insurance premiums” for caps, to protect its portfolio from a spike in short-term funding rates. The caps set the upper limits that the companies are exposed to if interest rates increase. Their P&L’s are exposed to interest rate hikes, up to the strike rate.

An interest rate floor is the opposite of a cap. It’s a contract that is written with a specified notional amount and a predetermined strike rate. The buyer gets paid if the market interest rate drops below the strike rate. It protects the purchaser (usually the borrower) from falling interest rates. Floors are particularly useful for lenders with adjustable rate assets and fix rate debt.

Let’s assume you have a lender issuing floating rate (adjustable) loans and capitalized with fixed rate debt, usually bonds. The lender would buy a floor to protect him if interest rates dropped.  If the interest rate decreases below the strike rate, the company would be paid for the interest differential. In effect, as the loans were re-priced downward, the floor would somewhat protect the margins. Caps and floors won’t completely lock in your profits, but they do reduce risk.

An interest rate collar is a combination play of purchasing a cap (or floor) and selling a floor (or cap). The strike prices are set within a band. The structure is used because the proceeds received by selling the floor (or cap) offset the cost of the cap (or floor).  

As with all derivatives, if you don’t control the offsetting notional amounts, you are exposed to a great deal of risk. Companies play the rate game all the time, and they make their bets by not being 100% hedged.  


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