Caps, Floors, & Collars Copyright 2014 by Diane S. Docking 1 collar.

Caps, Floors, & Collars

Copyright 2014 by Diane S. Docking 1

collar

Learning Objectives

Understand caps, floors, and collars Be able to set up a simple cap, floor,

or collar transaction

Copyright 2014 by Diane S. Docking2

Copyright 2014 by Diane S. Docking

Cap and Floor Agreements

Financial contracts can exist whereby one party agrees to compensate another for the difference between a designated

_________________and a pre-determined level, called the ______

___________ can be an interest rate, currency exchange rate, or even the return on a domestic or foreign stock market index

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Interest Rate Cap/Ceiling Agreements

A CAP is an agreement where the seller agrees to pay the buyer if the designated reference _________ the strike

The Payment or Rebate is given as: Notional Principal Amount x [Actual Value of Reference – Strike]

Rebateto buyer = (iindex/reference – icap strike) x Notional Principal Amount;

but only if iindex/reference > icap strike; else zero.

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Interest Rate Cap/Ceiling Agreements (cont.)

E.g.:CAP on LIBOR @ 4%

If LIBORt+1 = 5%, then buyer receives (seller pays):

(Reference – CAP) x Notional amount

5% - 4% = 1% x Notional amount

CAP is ITM: Reference > Strike


Nothing

CAP is OTM: Reference < Strike

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STRIKE rate

REFERENCE or INDEX


Uses of CAPS

1. Protects the Buyer of the Cap from Rising Interest Rates. Limits the Buyer’s interest rate exposure to a ____________ rate. The Cap is the purchase of a call option on interest rates or a put

option on prices. The Bank as Buyer of a Cap:

• Protects the bank from rising interest rates for an up front fee (option premium).

• Sets a maximum (cap) rate on the bank’s borrowing costs. The Bank as Seller of a Cap:

• Sets the maximum interest rate that the bank can earn on a customer loan.

• Protects the customer from rising interest rates.• Bank receives an up front fee (option premium) for this.

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Uses of CAPS (cont.)

2. Converts VR debt to FR debt, but only if rates increase Bank gets protection from increasing interest rates, yet retains the

benefits if rates decrease.• If rates decrease, receive 0 under cap and borrowing costs float down.• If rates increase, receive rebate of (Index – Cap) and sets a maximum

on expense.

3. Converts a FR loan to a VR loan, but only if rates increase Retains protection from decreasing interest rates, but gains

advantage of increasing rates.• Bank gets minimum revenue of the FR since Cap is OTM if rates fall.• But gets benefits of increasing rates because receive rebate of (Index –

Cap) which is added to the FR revenue.

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Interest Rate Floor Agreements

A FLOOR is an agreement where the seller agrees to pay the buyer if the designated reference ___________the strike

The Payment or Rebate is given as: Notional Principal Amount x [Strike – Actual Value of Reference]

Rebateto buyer = (ifloor strike – iindex/reference) x Notional Principal Amount;

but only if iindex/reference < ifloor strike; else zero.

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Interest Rate Floor Agreements (cont.)

Eg:FLOOR on LIBOR @ 4%


4% - 3% = 1% x Notional amount

FLOOR is ITM: Reference < Strike


Nothing

FLOOR is OTM: Reference > Strike

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STRIKE rate

REFERENCE or INDEX


Uses of FLOORS

1. Protects the Buyer of the Floor from Falling Interest Rates. Limits the Buyer’s interest rate exposure to a _____________ rate. The Floor is the purchase of a put option on interest rates or a call

option on prices. The Bank as Buyer of a Floor:

• Protects the bank from falling interest rates for an up front fee (option premium).

• Sets a minimum (floor) rate on the bank’s lending rates (and thus earnings).

The Bank as Seller of a Floor:• Sets the minimum interest rate that the bank must pay on bank

borrowings.• Protects the loaner from falling interest rates.• Bank receives an up front fee (option premium) for this concession.

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Uses of FLOORS (cont.)

2. Converts a VR loan to a FR loan, but only if rates fall Bank gets protection from decreasing interest rates, yet retains the

benefits if rates increase.• If rates fall, receive rebate of (Floor – Index) which is added to the VR

to guarantee a minimum revenue.• If rates increase, receive 0 under floor and revenue floats upward.

3. Converts FR debt to VR debt, but only if rates fall Retains protection from increasing interest rates, but gains

advantage of decreasing rates.• Bank pays maximum expense of the FR since Floor is OTM if rates

rise.• But gets benefits of decreasing rates because receive rebate of (Floor

– Index) which is added to the FR expense to reduce borrowing costs.11

Cap Example:

ABC Co. issued a $40 million 5-year bond at an interest rate = LIBOR + 1%. LIBOR is currently at 3%. At the same time ABC Co. purchased a 5-year cap on LIBOR with a strike = 3% and a premium of 0.5% of the notional amount.

Questions?:1) How much did the cap cost? How is this handled “accounting-

wise”?

2) Suppose at the end of year 1 the LIBOR = 4%. Does ABC receive a cap payment ; if so, how much?


4) What did ABC accomplish by purchasing this Cap?


Solution to Cap Example:

1) How much did the cap cost? How is this handled “accounting-wise”?




______. LIBOR Reference > CAP strike; therefore receive(Reference – CAP) x Notional amount

4% - 3% = 1% x $40 million = $400,000

______. LIBOR Reference < CAP strike; therefore receive $0.CAP is OTM.

The cap cost = premium x Notional Value = .005 x $40,000,000 = _______________. The $200,000 is paid “upfront”, but is amortized over the life of the cap. In this case $40,000 /yr to expense or 0.1% / yr.

Solution to Cap Example (cont):

4) What did ABC accomplish by purchasing this Cap?• Sets an upper bound on debt costs. Get lower debt costs if LIBOR

decreases; but if LIBOR increases, sets a maximum on debt cost.• Maximum debt cost = 4% x $40 million = $1,600,000 per year.

• Debt Cost bounds [1%; 4%] or [$400,000 ; $1,600,000]


CAP Strike = 3% If L < 3% If L > 3%

Debt cost - (L + 1%) - (L + 1%)

$40 million x (L+1%); for 5 yrs.

Cap receipt 0 L – 3%

Net debt cost - (L+1%) - 4%

Floor Example:

ABC Co. loaned $40 million to a customer for 5-years at an interest rate = LIBOR + 3%. LIBOR is currently at 4%. At the same time ABC Co. purchased a 5-year floor on LIBOR with a strike = 4% and a premium of 0.5% of the notional amount.

Questions?:1) How much did the floor cost? How is this handled “accounting-

wise”?

2) Suppose at the end of year 1 the LIBOR = 5%. Does ABC receive a floor payment ; if so, how much?


4) What did ABC accomplish by purchasing this Floor?


Solution to Floor Example:

1) How much did the floor cost? How is this handled “accounting-wise”?




______. LIBOR Reference > FLOOR strike; therefore receive $0.

______. LIBOR Reference < FLOOR strike; therefore receive (FLOOR - Reference) x Notional amount

4% - 2% = 2% x $40 million = $800,000

The floor cost = premium x Notional Value = .005 x $40,000,000 = $200,000. The $200,000 is paid “upfront”, but is amortized over the life of the cap. In this case $40,000 /yr to expense or 0.1% / yr.

Solution to Floor Example (cont):

3) What did ABC accomplish by purchasing this Floor?• Sets a lower bound on interest revenues. Get higher revenues if

LIBOR increases; but if LIBOR decreases, sets a minimum on interest revenues.

• Minimum interest revenue = 7% x $40 million = $2,800,000 per year.

• Revenue bounds [7%; +] or [$2,800,000 ; + ]


FLOOR Strike = 4% If L < 4% If L > 4%

Loan revenue L + 3% L + 3%


Floor receipt 4% - L 0

Net loan revenue 7% L + 3%

Interest Rate CollarSimultaneous _________ of an interest rate Cap

and ______ of an interest rate Floor,• On the same index,• For the same maturity, and• For the same notional principal amount.

Cap rate > Floor rate


Interest Rate Collar

Objective of Buyer of a Collar:To protect against rising interest rates and

increasing borrowing costs.The purchase of the Cap protects against

increasing interest rates.The sale of the Floor generates premium income

which reduces the cost of the Cap.Creates a band within which the buyer’s interest

rate costs will fluctuate.


Interest Rate Collar (cont.)

If iindex > icap, then

Rebateto buyer = (iindex - icap) x Notional Principal Amount;

(We receive since we are buyer of cap)

If iindex < ifloor, then

Rebateto buyer = (ifloor - iindex) x Notional Principal Amount;

(We pay to buyer since we are seller of floor)


Interest Rate Collar (cont.)

Interest Rate Reverse CollarSimultaneous ________ of an interest rate Floor

and ______ of an interest rate Cap,• On the same index,• For the same maturity, and• For the same notional principal amount.

Cap rate ≠ Floor rate


Interest Rate Reverse Collar

Objective of Buyer of a Reverse Collar:To protect against falling interest rates and

decrease in earnings.The purchase of the Floor protects against

decreasing interest rates.The sale of the Cap generates premium income

which reduces the cost of the Floor.Creates a band within which the buyer’s interest

rate earnings will fluctuate.


Interest Rate Reverse Collar (cont.)

If iindex > icap, then

Rebateto buyer = (iindex - icap) x Notional Principal Amount;

(We pay to buyer since we are seller of cap)

If iindex < ifloor, then

Rebateto buyer = (ifloor - iindex) x Notional Principal Amount;

(We receive since we are buyer of floor)


Interest Rate Reverse Collar (cont.)

Collar Example:

ABC Co. issued a $40 million 5-year bond at an interest rate = LIBOR + 1%. LIBOR is currently at 4%. At the same time ABC Co. purchased a 5-year cap on LIBOR with a strike = 4% and a premium of 0.5% of the notional amount and sold a 5-year floor on LIBOR with a strike rate of 3.0% and a premium of 0.5% of the notional amount.

Questions?:1) What is the net cost of the collar and how is it handled “accounting-wise”?

2) Suppose at the end of year 1 the LIBOR = 5%. Does ABC receive a cap payment or make a floor payment; if so, how much?


4) Suppose at the end of year 1 the LIBOR = 3.5%. Does ABC receive a cap payment or make a floor payment; if so, how much?

5) What did ABC accomplish by purchasing this Collar?


Solution to Collar Example:

1) What is the net cost of the collar and how is it handled “accounting-wise”?



The cap cost = premium x NV = .005 x $40,000,000 = $200,000. The floor revenue = premium x NV = .005 x $40,000,000 = $200,000. Both premiums are paid up front. This is a “______________” collar. In this case $0 /yr to expense or 0.0% / yr.

LIBOR Reference > CAP strike 5% > 4%

therefore receive (Reference – CAP) x Notional amount5% - 4% = 1% x $40 million = $400,000

LIBOR Reference > FLOOR strike; therefore pay $0 5% > 3%




LIBOR Reference < CAP strike; therefore receive $02% < 4%

LIBOR Reference < FLOOR strike; 2% < 3%therefore pay (FLOOR -Reference) x Notional amount

3% - 2% = 1% x $40 million = $400,000


4) Suppose at the end of year 1 the LIBOR = 3.5%. Does ABC receive a cap payment or make a floor payment; if so, how much?


LIBOR Reference < CAP strike; therefore receive $0 3.5% < 4%

LIBOR Reference > FLOOR strike; therefore pay $0 3.5% > 3%


5) What did ABC accomplish by purchasing this Collar?• Set an upper and lower bound on interest expense. • Maximum interest expense = 5% x $40 million = $2,000,000 per year.• Minimum interest expense = 4% x $40 million = $1,600,000 per year.

• Cost bounds [4%; 5%] or [$1,600,000 ; $2,000,000 ]


CAP Strike = 4%; Floor Strike = 3% If L < 3% If 3% < L < 4% If L > 4%

Debt cost - (L + 1%) - (L + 1%) - (L + 1%)


Cap receipt 0 0 L – 4%

Floor payment -(3% - L) 0 0

Net debt cost - 4% - (L + 1%) - 5%

Caps, Floors, & Collars Copyright 2014 by Diane S. Docking 1 collar.

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Transcript of Caps, Floors, & Collars Copyright 2014 by Diane S. Docking 1 collar.