What is a Cap?

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An interest rate cap is a type of interest rate derivative in which the buyer receives payments at the end of each period in which the interest rate exceeds the agreed strike price. An example of a cap would be an agreement to receive a payment for each month the LIBOR rate exceeds 2. Similarly an interest rate floor is a derivative contract in which the buyer receives payments at the end of each period interest rate cap call option which the interest rate is below the agreed strike price.

Caps and floors can be used to hedge against interest rate fluctuations. For example, a borrower who is paying the LIBOR rate on a loan can protect interest rate cap call option against a rise in rates by buying a cap at 2. If the interest rate exceeds 2. An interest rate cap is a derivative in which the buyer receives payments at the end of each period in which the interest rate exceeds the agreed strike price. They are most frequently taken out for periods of between 2 and 5 years, although this can vary considerably.

The purchaser of a cap will continue to benefit from any rise in interest rates above the strike price, which makes the cap a popular means of hedging a floating interest rate cap call option loan for an issuer. The interest rate cap can be analyzed as a series of European call optionsknown as caplets, which exist for each period the cap agreement is in existence. To exercise a cap, its purchaser generally does not have to notify the interest rate cap call option, because the cap will be exercised automatically if the interest rate exceeds the strike rate.

Each caplet is settled in cash interest rate cap call option the end of the period to which it relates. An interest rate floor is a series of European put options or floorlets on a specified reference rateusually LIBOR. The buyer of the floor receives money if on the maturity of any of the floorlets, the reference rate is below the agreed strike price of the floor. An interest rate collar is the 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.

A reverse interest rate collar is the simultaneous purchase of an interest rate floor and simultaneously selling an interest rate cap. The simplest and most common valuation of interest rate caplets is via the Black model. Notice that there is a one-to-one mapping between the volatility and the present value of the option. Because all the other terms arising in the equation are indisputable, there is no ambiguity in quoting the price of a caplet simply by quoting its volatility.

This is what happens in the market. The volatility is known as the "Black vol" or implied vol. As negative interest rates became a possibility and then reality in many countries at around the time of Quantitative Easingso the Black model became increasingly inappropriate as it implies a zero probability of negative interest rates. Many substitute methodologies have been proposed, including shifted log-normal, normal and Markov-Functional, though no new standard is yet to emerge. Thus if we have an interest rate model in which we are able to value bond puts, we can value interest rate caps.

Similarly a floor is equivalent to a certain bond call. Several popular short rate modelssuch as the Hull-White model have this degree of tractability. Thus we can value caps and floors in those models.

Caps based on an underlying rate like a Constant Maturity Swap Rate cannot be valued using simple techniques described above. From Wikipedia, interest rate cap call option free encyclopedia. Retrieved from " https: Views Read Edit View history. This page was last edited on 7 Aprilat By using this site, you agree to the Terms of Use and Privacy Policy.

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Technology for Financial Risk Professionals which helps them increase client revenues and retention. Start the free trial. An interest-rate cap is an OTC derivative that protects the holder from rises in short-term interest rates by making a payment to the holder when an underlying interest rate the "index" or "reference" interest rate exceeds a specified strike rate the "cap rate".

Caps are purchased for a premium and typically have expirations between 1 and 7 years. They may make payments to the holder on a monthly, quarterly or semiannual basis, with the period generally set equal to the maturity of the index interest rate. Each period, the payment is determined by comparing the current level of the index interest rate with the cap rate. If the index rate exceeds the cap rate, the payment is based upon the difference between the two rates, the length of the period, and the contract's notional amount.

A cap has an insurance characteristic through the payment of the premium while sustaining the chance to benefit from constant or even falling interest rates. The benefit is the greatest, as with buying any option, when interest rates are going down and no compensation payments will be made assumption. Caps are usually quoted with an up-front premium. Caps and floors can be bought and sold like any other financial instrument. If a client has purchased a cap or a floor and wishes to unwind the transaction, they would simply sell it back to the bank at the prevailing market price.

As each variable changes, the value of the greater-than or equal to zero. Volatility is lower at the long end of the curve compared to the short end highest in 3y maturity bucket. At normal steep yield curve, caps are significantly more expensive than in a flat or even inverse yield curve environment.

Cap Cap buyer Cap seller Feature Leads to compensation payments when the upper limit is being exceeded Keeps the premium when upper limit is not being exceeded Intention Expectation to participate at low money market interest rates and to hedge against increasing interestrates.

Interest cost reduction or yield enhancement Risk Limited to paid option premium Return never greater than cap premium. We are constantly expanding our functionality and improving the user experience.

This requires to make changes from time to time. This may result in small discrepancies between the help section and system, for which we apologise. Print this What is a Cap? Treasury Management Products Derivatives. Expectation to participate at low money market interest rates and to hedge against increasing interestrates.