FINC 4320

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FINC 4320

• Interest Rate Caps, Floors and Collars

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Interest Rate Caps and Floors

• Cap - a series of European interest rate call
  options used to protect against rate moves above
  a set strike level
• Floor - a series of European interest rate put
  options used to protect against rate moves below
  a set strike level
• Recall some basic option valuation points, and
  apply them to caps and floors

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The buyer of a cap receives a cash payment from
the seller. The payoff is the maximum of 0 or
3-month LIBOR minus 4 times the notional
principal amount.

• If 3-month LIBOR exceeds 4, the buyer receives
  cash from the seller and nothing otherwise.
• At maturity, the cap expires.

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Interest Rate Caps and Floors

• Example a three-year cap, n.p. of 100,000 with
  a strike rate of 9.6
• 13.824
• 4224
• 11.52
• 1920
• 9.6 9.6
• 8.0 8.0
• 6.667 6.667
• 5.556
• 4.629

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Interest Rate Caps and Floors

• Example a three-year floor, n.p. of 1000,000
  with a strike rate of 6
• 13.824
• 11.52
• 9.6 9.6
• 8.0 8.0
• 6.667 6.667
• 5.556
• 444
• 4.629
• 1370

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What about Collars?

• Interest rate collarthe simultaneous purchase
  of an interest rate cap and sale of an interest
  rate floor on the same index for the same
  maturity and notional principal amount.
• The cap rate is set above the floor rate.
• The objective of the buyer of a collar is to
  protect against rising interest rates.
• The purchase of the cap protects against rising
  rates while the sale of the floor generates
  premium income.
• A collar creates a band within which the buyers
  effective interest rate fluctuates.

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And Reverse Collars?

• Reverse collarbuying an interest rate floor and
  simultaneously selling an interest rate cap.
• The objective is to protect the bank from falling
  interest rates.
• The buyer selects the index rate and matches the
  maturity and notional principal amounts for the
  floor and cap.
• Buyers can construct zero cost reverse collars
  when it is possible to find floor and cap rates
  with the same premiums that provide an acceptable
  band.

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The size of cap and floor premiums are determined
by a wide range of factors

• The relationship between the strike rate and the
  prevailing 3-month LIBOR
• premiums are highest for in the money options and
  lower for at the money and out of the money
  options
• Premiums increase with maturity.
• The option seller must be compensated more for
  committing to a fixed-rate for a longer period of
  time.
• Prevailing economic conditions, the shape of the
  yield curve, and the volatility of interest
  rates.
• upsloping yield curve -- caps will be more
  expensive than floors.
• the steeper is the slope of the yield curve,
  ceteris paribus, the greater are the cap
  premiums.
• floor premiums reveal the opposite relationship.

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Putting It All Together

• What are the the relationships among swaps, caps
  and floors? Think about this
• Floor Cap - Swap
• Cap Floor Swap
• HOW?