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Caps and Floors
Interest rate caps and floors are options used in the derivatives market to control hedge costs and manage risk by protecting against adverse interest rate movements. The purchaser of a cap or floor pays an up-front premium, which is based upon the period of time covered and the strike rate.
Interest Rate Cap
An interest rate cap creates a ceiling or “cap” on floating rate interest costs. The cap purchaser receives a payment when market rates move higher than the cap (or strike) rate. For example, a borrower receives 1.5% on a floating rate basis and they purchase a 2.5% cap to protect against rising interest rates. The borrower would receive a payment for each period that the rate exceeds 2.5%. The cap ensures that the borrower’s interest rate costs never exceed the cap rate.
Interest Rate Floor
An interest rate floor is the opposite of a cap in that it creates a floor on interest rates in order to guarantee a minimum rate of return. The floor purchaser receives a payment when market rates move lower than the floor (or strike) rate. For example, a borrower that is receiving a 3.0% floating rate buys a 1.5% floor to protect against falling interest rates. The borrower would receive a payment at the end of each period that interest rates have fallen below 1.5%.
At Blue Rose we have in-house derivatives experts that assist clients with the effective use of caps and floors as part of their broader interest rate and risk management strategies.
Cancellation Options
A swap cancellation option can be an attractive choice for a borrower that wants to limit the risk of adverse rate moves in the future, reduce potential costs or losses resulting from an early termination, or lower collateral posting amounts. Purchased at the time the swap is executed, the cancellation option gives the purchaser the right, but not the obligation, to terminate the swap at one or more points in the future, for no additional cost. The borrower will pay for the cancellation option through a fee that is embedded in the swap rate, thus paying a higher interest rate than they would without the option. The price paid for the option will depend upon the length of the lockout period (the period where the swap can’t be cancelled) and on which of the three types of cancellation options is purchased: European with one exercise date, Bermudan with multiple exercise dates, or American, which can be cancelled any time. If the interest rate environment is positive and the swap is an asset at the time of termination, the borrower can choose to unwind the swap to their advantage rather than exercise the cancellation option. Cancellation options should be evaluated for cost effectiveness, especially with longer term transactions.