What Is a Caplet?
A caplet is a kind of call option based on interest rates. The typical use of a caplet is to limit the costs of rising interest rates for those corporations or governments that must pay a floating rate of interest on bonds they have issued. However, as with all derivatives, commercial speculators may trade caplets for short-term gains.
- Caplets are interest rate options designed to "cap" the risk of rising rates.
- These options use an interest rate, rather than a price, as the basis for a strike.
- Caplets are shorter term (90 days) in duration compared to caps which may be a year or longer.
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How a Caplet Works
Caplets are usually based on an interbank interest rate, such as LIBOR. That's because they are typically used for hedging the risk of LIBOR rising. For example, if a company issues a bond with a variable rate of interest to take advantage of a short-term drop in rates, they run the risk of greater payouts if interest rates begin to increase and continue to do so. At this point they would be paying out more on the loan (bond) interest payments than they had hoped. If interest rates rose rapidly it could spell disaster for them. Buying an option to cap the interest rate they have to pay would protect them from this disaster.
According to an announcement by the Federal Reserve in November 2020, banks should stop writing contracts using LIBOR by the end of 2021. The Intercontinental Exchange, the authority responsible for LIBOR, will stop publishing one week and two month LIBOR after December 31, 2021. All contracts using LIBOR must be wrapped up by June 30, 2023.
In this scenario, the option buyer may opt for a longer term (one or more years) of protection. To accomplish this, an option buyer may combine several caplets in a series to create a "cap" so as to manage longer-term liabilities. (The term caplet implies a shorter duration of the cap. A caplet's duration is usually only 90 days).
If a trader buys a caplet they would be paid if LIBOR rose above their strike price; they would receive nothing if LIBOR fell below their strike price, so it acts as an insurance against rising rates. Traders time a caplet's expiration to coincide with a future interest rate payment.
Interest Rate Hedging
Because caplets are European-style call options, meaning they can only be exercised at expiration, they can also be used by traders. Traders who want to profit from higher interest rates for short-term events have less chance of having the option exercised against them.
Caplets and caps are used by investors to hedge against the risks associated with floating interest rates. Imagine an investor who has a loan with a variable interest rate that will rise or fall with LIBOR. Assume that LIBOR is currently 6% and the investor is worried that rates will rise before the next interest payment is due in 90 days. To hedge against this risk, the investor can buy a caplet with a strike rate of 6% and an expiration date at the interest payment date. If LIBOR rises, the value of the caplet option will also rise. If LIBOR falls, the caplet could become worthless.
A caplet's value is calculated as:
Max((LIBOR rate – caplet rate) or 0) x principal x (# of days to maturity/360)
If LIBOR rises to 7% by the interest payment date and the investor is paying quarterly interest on a principal amount of $1,000,000, then the caplet will pay off $2,500. You can see how this payoff was determined in the following calculation:
= (.07 – .06) x $1,000,000 x (90/360) = $2,500
If an investor needs to hedge a longer-term liability with several interest payment due dates then several "caplets" can be combined into a "cap." For example, let's assume an investor has a two-year loan with interest-only, quarterly payments. The investor can purchase a two-year cap based on the three-month LIBOR rate. This investment is composed of seven caplets and each caplet covers three months. The price of the cap is the sum of the price of each of the seven caplets.