Derivatives - Interest Rate Caps and Floors
Interest Rate Cap
An interest rate cap is actually a series of European interest call options (called caplets), with a particular interest rate, each of which expire on the date the floating loan rate will be reset. At each interest payment date the holder decides whether to exercise or let that particular option expire. In an interest rate cap, the seller agrees to compensate the buyer for the amount by which an underlying short-term rate exceeds a specified rate on a series of dates during the life of the contract. Interest rate caps are used often by borrowers in order to hedge against floating rate risk.
(Current market rate - Cap Rate) x principal x (# days to maturity/360)
Interest Rate Floor
Floors are similar to caps in that they consist of a series of European interest put options (called caplets) with a particular interest rate, each of which expire on the date the floating loan rate will be reset. In an interest rate floor, the seller agrees to compensate the buyer for a rate falling below the specified rate during the contract period. A collar is a combination of a long (short) cap and short (long) floor, struck at different rates. The difference occurs in that on each date the writer pays the holder if the reference rate drops below the floor. Lenders often use this method to hedge against falling interest rates.
The cash paid to the holder is as follows:
(Floor rate - Current market rate) x principal x (# days to maturity/360)