Caps, Floors and Collars

Caps, Floors and Collars are option based interest rate risk management products that put limits to the interest rates. A barrower may want to limit the interest rate to avoid any rises in the future and buys a cap. Or investor may buy a floor to avoid any future falls in the interest rates. Anyone who aims to maintain interest rates within defined range can use the combination (collar).

Given the £50 million loan over 2 years period we can make speculation how cap, floor and collar would make a difference. We assume that interest rate rises .5% each quarter in 2 years, starting from 2%. A company would like to buy “cap” at 4% for hedging purposes costing £100,000. Table 1 would show hedged payments for such a scenario.

 

Quarters Assumed
LIBOR
Interest due
[ (LIBOR) x (1/4) x 50M ]
Cap Payoff
[ MAX(LIBOR- 0.04,0) x (1/4) x 50M ]
Hedged Interest Payment Hedged Rate
1/8 2%   -100,000    
2/8 2.5% 250,000 0 250,000 2%
3/8 3% 312,500 0 312,500 2.5%
4/8 3.5% 375,000 0 375,000 3%
5/8 4% 437,500 0 437,500 3.5%
6/8 4.5% 500,000 0 500,000 4%
7/8 5% 562,500 62,500    500,000 4%
8/8 5.5% 625,000 125,000 500,000 4%
    687,500 187,500 500,000 4%
Table 1 – Interest rate cap example

As seen from the table even if the interest keeps rising above the 4% level, company is only liable to pay £500,000 and its hedged rate is just limited to 4%. Company pays a premium of £100,000 at the beginning but then in the last 3 quarters the hedged payments payoffs.

Similar to the example above, a loaner may want to use “floor” to establish minimum rate. This would let the loaner lock the minimum rates while benefiting with higher returns if rates increase.  A floor agreement might be held at 4%, costing £100,000. The result of cash flows would be something like in table 2.

Quarters Assumed
LIBOR
Interest received
[ (LIBOR) x (1/4) x 50M ]
Floor Payment
[ MAX(LIBOR- 0.04,0) x (1/4) x 50M ]
Hedged Interest Payment Hedged Rate
1/8 2%   -100,000    
2/8 2.5% 250,000 0 250,000 2%
3/8 3% 312,500 187,500 500,000 4%
4/8 3.5% 375,000 125,000 500,000 4%
5/8 4% 437,500 62,500 500,000 4%
6/8 4.5% 500,000 0 500,000 4%
7/8 5% 562,500 562,500 4.5%
8/8 5.5% 625,000 0 625,000 5%
    687,500 0 687,500 5.5%
Table 2 – Interest rate floor example

By using floor, company is able to lock its minimum hedged rate at 4% for the 2nd 3rth and 4th quarters, while receiving higher rates later. Initial £100,000 floor premium payoffs later as hedged interests received.

There is also another way of hedging the borrowed loan using “collar”. If the borrower wants to put maximum limit to its interest rate, cap would do the work. Borrower has to pay the premium for this service. However, even this premium can be avoided by selling floor and receiving floor premium. Selling a floor will bring the obligation of payment, if the rates fall below the agreed level, but borrower itself also benefits from the lower interest rates. Suppose our company buys a cap at 5% costing £100,000 and sells a floor at 3% receiving £80,000. Table 3.3 shows hedged cash flows for such scenario. 

Quarters Assumed
LIBOR
Interest due
[ (LIBOR) x (1/4) x 50M ]
Floor Payment
[ MAX(LIBOR- 0.04,0) x (1/4) x 50M ]
Cap Payoff
[ MAX(LIBOR- 0.04,0) x (1/4) x 50M ]
Hedged Interest Payment Hedged Rate
1/8 2%   80,000 -100,000    
2/8 2.5% 250,000 0 0 250,000 2%
3/8 3% 312,500 -62,500 0 375,000 3%
4/8 3.5% 375,000 0 0 372,000 3%
5/8 4% 437,500 0 0 437,000 4%
6/8 4.5% 500,000 0 0 500,000 4.5%
7/8 5% 562,500 562,500 5%
8/8 5.5% 625,000 0 62,500 562,500 5%
    687,500 0 125,000 562,500 5%
Table 3 – Interest rate collar example

As seen from the table, borrower is already reducing its premium costs to £100,000-£80,000 = £20,000 buy selling floor and also limiting its interest costs at 5% when interest rate rises above the cap level. The obligation of floor payments would not really bother the borrower, since it is also taking advantage of direct borrowing from lower interest rates.

1 comment:

Sam Williams said...

Collars didn't seem like a financial term to me. I guess a cap and a floor aren't either. longcollar.com This site has a layman's terms description, that was a little easier for me to handle. Check it out. Or don't.