Interest rate caps and floors

Caps
A borrower will hedge against the risk of interest rate rises by buying a put option over interest rate futures.
A cap is another name for this put option over interest rate futures.

Floors
Similarly, a depositer will hedge against the risk of interest rate falls by buying a call option over interest rate
futures.
Such an option can also be called a floor.

Interest rate collars

A company buys an option to protect against an adverse movement whilst allowing it to take advantage of a
favourable movement in interest rates. The option will be more expensive than a futures hedge. The company
must pay for the flexibility to take advantage of a favourable movement.
A collar is a way of achieving some flexibility at a lower cost than a straight option.
Under a collar arrangement the company limits its ability to take advantage of a favourable movement by selling
an option (as well as buying one to hedge adverse movements). The premium received from the sale will help
pay for the premium on the option we need to buy.

For example, for a borrower, it buys a cap (a put option) as normal but also sells a floor (a call option) on
the same futures contract, but with a different exercise price.

The floor sets a minimum cost for the company. The counterparty is willing to pay the company for this
guarantee of a minimum income. Thus the company gets paid for limiting its ability to take advance of a
favourable movement if the interest rate falls below the floor rate the company does not benefit
therefore the counterparty does.

It involves a company arranging both a minimum and a maximum limit on its interest rates payments or
receipts. It enables a company to convert a floating rate of interest into a semi-fixed rate of interest.

An Introduction to Caps, Floors, Collars and Swaptions

Date 7/5/2010

Posted in Summer 2010, Feature

Organizations seeking to stabilize cash flow, mitigate susceptibility to interest rate swings or
otherwise structure a desired interest exposure should consider the variety of liability-hedging
tools available to mitigate interest rate risk and volatility on existing debt. These tools including caps, floors, collars, swaps and swaptions are negotiated contracts that can
provide fairly precise levels of interest rate control over a specified time period. Additional
benefits include creating a more flexible financial structure, reducing borrowing costs,
matching rate-sensitive assets and liabilities, and diversifying financial risks and/or
increasing investment returns.
Derivatives such as these have received bad press lately, partially because of highlypublicized cases of unscrupulous transactions that took advantage of borrowers lack
of understanding. When understood and properly applied, however, these tools can
be logical resources that provide strong benefits to organizations with outstanding
debt.

Interest Rate Caps

An interest rate cap puts an upper limit on a borrowers variable interest rate. The
organization with the debt to be hedged pays an upfront fee to purchase a cap from
a financial counterparty. Pricing depends on current rate movements, on how high
the cap is set, and for how long. The financial counterparty is then responsible for
any interest costs beyond the cap rate, should rates rise that high. All else being
equal, a 7% cap set for 10 years will cost less than a 4% cap set for 20 years.
The organization retains the full benefit of lower variable rates while protecting itself
from a spike in interest rates above the cap level. A cap cannot become a liability to
the organization (unlike a swap), as it contains only one-way obligations to the
financial counterparty after the upfront fee has been paid. Therefore, an
organizations credit risk is not considered in the pricing of the cap. Lastly, if the
organization wants to terminate a cap before it matures, the organization will receive
a payment for the caps residual value; the higher current rates are, the higher the
value. Ultimately, a cap is best suited for an organization looking to minimize its
exposure to rising short-term interest rates.

Interest Rate Floor

An interest rate floor places a lower limit on variable interest rates for a chosen
period of time. In this situation, the organization is the seller rather than the buyer.
The financial counterparty pays an upfront fee to the organization to minimize the
financial counterpartys exposure to declining short-term interest rates. The higher
the probability the floor will be pierced (the higher the floor), the higher the fee. An
organization will receive a higher upfront fee for a 4% floor for 20 years than a 2%
floor for 10 years, all else being equal.
A floor provides the organization a tool to monetize the value of its variable-rate
debt. If rates remain above the floor, the organization keeps its upfront fee but need
not pay anything out to the counterparty. But in exchange for this upfront fee, the
organization assumes an ongoing liability for the term of the floor. If rates decline
below the floor level, then the organization pays the financial counterparty the
difference between the floor rate and the variable rate multiplied by the notional
value of the floor.
Because the organization assumes an ongoing liability when selling a floor, the
financial counterparty will consider the organizations credit profile when pricing the
upfront payment; lower credits will receive lower upfront fees. In addition, if the
organization wishes to terminate the floor early, it will have to pay the financial
counterparty a fee based on the residual value of the floor (the lower current rates
are, the higher the value). Lastly, an organization selling a floor gives up its access to
interest rates below the floor level.

Interest Rate Collar

A common motivation for an organization to sell a floor is to raise cash to purchase a
cap, which creates an interest rate collar which bounds the organizations variablerate debt by the chosen cap and floor rates. The organization is protected from
paying interest rates above the interest rate cap level but has given up the benefit of
variable rates below the interest rate floor level. Though a collar does not provide for
a fixed interest rate like a swap, it does provide a bounded range of future interest
rate expense, enabling more accurate budgeting and cash flow forecasts.

Interest rate collar: This organization has purchased a 5% cap and sold a 2% floor,
which provides the organization with an interest rate collar of 2% to 5%.

Interest Rate Swap

In hedging variable-rate debt with a swap, an organization agrees to pay out a fixed
amount each month to a counterparty in exchange for receipt of a variable-rate
payment that approximates the organizations debt service payment. The
organization thereby effectively pays a fixed rate on its debt. There is no exchange of
principal or upfront fee; only payment of the loans interest is impacted.
A borrower can fix all or only a part of the variable-rate debt, for any time period.
Additional explanation can be found in An Introduction to Interest Rate Swaps from
the Winter 2008 edition of The Capital Issue.

Interest Rate Payer Swaption

An interest rate swaption is an option to enter into an interest rate swap at some
point in the future, up until a specified maturity date. The buyer of the swaption (the

organization) pays a counterparty a one-time upfront fee that depends on interest

rate volatility, the length of time until the swaption expires, and the rate at which the
swap would be fixed, known as the exercise rate. If the organization chooses never
to exercise the swaption, its maximum loss is the upfront fee, whereas if rates rise
considerably, the organization can enter into a swap and save the difference
between the exercise rate and current swap rates, which can be considerable in a
volatile interest rate environment.
An organization should consider buying a payer swaption if it expects to issue
variable-rate debt within the next few years and it believes interest rates will
increase.
Swaptions can also be used by organizations that plan to issue fixed-rate debt, as a
hedge against rising interest rates. If interest rates rise, the value of the payer
swaption increases. In this case, the organization could sell the swaption and use the
proceeds to buy down its fixed rate on a forthcoming debt issuance, issuing bonds at
a discount.
With interest rates at historically low levels, organizations should consider the
potential impact rising interest rates may have on their financial profiles. Caps,
floors, collars, swaps and swaptions remain an effective strategy to hedge against
interest rate volatility and improve day-to-day cash flow stability.

Cap floors collars

Definition
Cap:
A cap is a maximum interest rate agreed upon in a contract. The seller of the cap must
pay the buyer the difference between an agreed interest rate (cap rate) and a defined
reference interest rate (such as 3-month Euribor) if the reference interest rate is higher
than the interest rate cap on the defined dates of interest rate determination. This
compensation payment is calculated on the basis of an agreed nominal amount and for a
fixed term. The cap seller receives compensation for this obligation in the form of a oneoff premium or regular payments from the cap buyer.
Floor:
The counterpart to caps, floors are minimum interest rates agreed upon in a contract.
The buyer of a floor is entitled to demand a payment from the seller to the value of the
amount by which an agreed reference interest rate falls below the agreed minimum
interest rate (floor). In return for this, the buyer pays the option writer (seller) a premium.
The two instruments are similar as regards the configuration and technical processing of
the contract.
Collar:

A collar is an interest rate hedging instrument that is based on the combination of a cap
and a floor. A collar represents a contractual agreement for an interest rate floor and an
interest rate cap at the same time. For example, borrowers can use collars to allow their
variable interest payables to fluctuate in fixed ranges.
The buyer of a collar is both the buyer of a cap and the seller of a floor. The buyer of a
collar receives a compensation payment from the seller of the collar if a particular
interest rate is exceeded. However, the buyer must make a payment to the seller of the
collar if the interest rate falls below the agreed interest rate floor. As the buyer of the
cap, the buyer of the collar pays a premium for the right to limit his maximum interest
rate risk. On the other hand, as the seller of the floor, he receives a premium. However,
in his function as option writer, he cannot profit from possible falls in interest rates below
the agreed interest rate floor.

Use
Caps, floors, and collars are used in the Analyzers for the Basel II and SAP Accounting for
Financial Instruments.
For detailed information about the individual objects, see the Business Content
Documentation Tool (Access database).

Who uses Interest Rate Caps?

Variable rate borrowers are the typical users of Interest Rate Caps. They use Caps to
obtain certainty for their business and budgeting process by setting the maximum
interest rate they will pay on their borrowings. By implementing this type of financial
management, variable rate borrowers obtain peace of mind from rising interest rates
but retain the ability to benefit from any favourable interest rate movements.
How does an Interest Rate Cap work?
An Interest Rate Cap ensures that you will not pay any more than a pre-determined
level of interest on your loan. St.George will reimburse you the extra interest
incurred should interest rates rise above the level of the Cap. An Interest Rate Cap
enables variable rate borrowers to retain the advantages of their variable rate facility
while obtaining the additional benefits of a maximum interest rate.
How much does an Interest Rate Cap cost?
The cost of the Cap is referred to as the premium. The premium for an Interest Rate
Cap depends on the Cap rate you want to achieve when compared to current market
interest rates. For example, if current market rates are 6%, you would pay more for a
Cap at 7% than a Cap at 8.5%. The premium for an Interest Rate Cap also depends
on the rollover frequency and how you make your premium payments. We will
endeavour to structure the payments to suit your cash flows. Your St.George

Financial Markets representative will be happy to provide an indication of costs when

you discuss your requirements with them.
Over what period can I obtain a Cap?
An Interest Rate Cap can be purchased for a minimum term of 90 days and a
maximum term of five years. When the Actual Interest Rate rises above the Cap
Strike Rate the Bank will reimburse the extra interest to the customer.
Is there a minimum amount for an Interest Rate Cap?
We will be pleased to quote on Interest Rate Caps of $1,000,000 or more.
What happens if I repay my loan early? Can I cancel the Cap?
Interest Rate Caps are totally separate to your loan facility (you may have even
borrowed from another bank and entered into an Interest Rate Cap with St.George).
If at any time you repay these borrowings you can either let the Cap run to maturity
or you may terminate it. Depending on interest rate movements there may be some
remaining value of the Cap. The Bank will pay this remaining value to you on
termination.
Are there any risks associated with an Interest Rate Cap?
There are no risks associated with an Interest Rate Cap. It is important to understand
that if interest rates do not rise above the Cap rate, you have not obtained any
benefit from the purchase of the Cap.
What other information is required?
If you decide you can benefit from an Interest Rate Cap you will be required to sign
the Bank's standard terms and conditions. These documents are easy to read as they
have been written in plain English. They summarise the terms and conditions under
which you agree to deal with the Bank.
How do I arrange a Cap?
Please phone your St.George Financial Markets representative to discuss your needs.

Interest Rate Collars - Borrowers - FAQs

Who uses Interest Rate Collars?

Variable rate borrowers are typical users of Interest Rate Collars. They use Collars to
obtain certainty for their borrowings by setting the minimum and maximum interest
rate they will pay on their borrowings. By implementing this type of financial
management, variable rate borrowers obtain peace of mind from the knowledge that
interest rate changes will not impact greatly on the borrowing costs, with the
resultant freedom to concentrate on other aspects of their business.
An Interest Rate Collar is simply a combination of an Interest Rate Cap and an
Interest Rate Floor. You receive payment of a premium from St.George to purchase
the Interest Rate Floor which offsets the premium that you pay for the Interest Rate
Cap. As such the premiums payable for an Interest Rate Collar are less than the
premium payable for an Interest Rate Cap.
How does an Interest Rate Collar work?
An Interest Rate Collar ensures that you will not pay any more than a pre-determined
level of interest on your borrowings. St.George will reimburse you the extra interest
should interest rates rise above the level of the Cap. An Interest Rate Collar however,
will not allow you to take advantage of interest rates below a pre-determined level.
You will be required to reimburse St.George the extra interest should interest rates
fall below the level of the Floor. An Interest Rate Collar enables variable rate
borrowers to retain the advantages of their variable rate facility while obtaining the
additional benefits of a maximum interest rate, at a reduced cost to an Interest Rate
Cap.
How much does an Interest Rate Collar cost?
The cost of the Collar is referred to as the premium. The premium for an Interest
Rate Collar depends on the rate parameters you want to achieve when compared to
current market interest rates. For example, as a borrower with current market rates
at 6%, you would pay more for an Interest Rate Collar with a 4% Floor and a 7% Cap
than a Collar with a 5% Floor and a 8.5% Cap.
The premium for an Interest Rate Collar also depends on the rollover frequency and
how you make your premium payments. We will endeavour to structure the
payments to suit your cash flows. It is possible to achieve a net zero premium. Your
St.George Financial Markets representative will be happy to provide an indication of
costs when you discuss your requirements with them.
Over what period can I obtain a Collar?
An Interest Rate Collar can be purchased for a minimum term of 90 days and a
maximum term of five years.
For borrowers, should the actual interest rate rise above the Cap Strike Rate,
St.George will reimburse you the extra interest. If the actual interest rate fall below
the Floor Strike Rate, you will reimburse the extra interest to St.George.

Is there a minimum amount for an Interest Rate Collar?

We will be pleased to quote on Interest Rate Collars of $1,000,000 or more.
What happens if I need to repay my loan early? Can I cancel the Collar?
Interest Rate Collars are totally separate to your borrowings (you may have even
borrowed from another bank and entered into an Interest Rate Collar with
St.George). If at any time you need to retire your borrowings, you can either let the
Collar run to maturity or you may terminate it.
Depending on interest rate movements there may be some remaining value of the
Collar. The Bank will pay this remaining value to you on termination.
Are there any risks associated with an Interest Rate Collar?
There are risks associated with an Interest Rate Collar. It is important to understand
that if interest rates fall below the Floor rate, you will have missed out on the
potential reduction to your cost of funds. The cost advantages over an Interest Rate
Floor may or may not compensate for this potential loss. Only you can decide if the
premium savings outweigh the potential of reduced cost in a falling interest rate
environment.
What other information is required?
If you decide you can benefit from an Interest Rate Collar you will be required to sign
the Bank's standard terms and conditions. These documents are easy to read as they
have been written in plain English. They summarise the terms and conditions under
which you agree to deal with the Bank.
How do I arrange a Collar?
Please phone your St.George Financial Markets representative to discuss your needs.

Interest Rate Floors - FAQs

Who uses Interest Rate Floors?

Variable rate investors are the typical users of Interest Rate Floors. They use Floors
to obtain certainty for their investments and budgeting process by setting the
minimum interest rate they will receive on their investments. By implementing this
type of financial management, variable rate investors obtain peace of mind from

falling interest rates and the freedom to concentrate on other aspects of their
business/investments.
Q. How does an Interest Rate Floor work?
An Interest Rate Floor ensures that you will not receive any less than a predetermined level of interest on your investment. The Bank will reimburse you the
extra interest incurred should interest rates fall below the level of the Floor.
An Interest Rate Floor enables variable rate investors to retain the upside
advantages of their variable rate investment while obtaining the comfort of a known
minimum interest rate.
How much does an Interest Rate Floor cost?
The cost of the Floor is referred to as the premium. The premium for an Interest Rate
Floor depends on the Floor rate you want to achieve when compared to current
market interest rates. For example, if current markets rates are 6%, you would pay
more for a Floor at 5% than a Floor at 4.5%.
The premium for an Interest Rate Floor also depends on the rollover frequency and
how you make your premium payments. We will endeavour to structure the
payments to suit your cash flows. Your St.George Financial Markets representative
will be happy to provide an indication of costs when you discuss your requirements
with them.
Q. Over what period can I obtain a Floor?
An Interest Rate Floor can be purchased for a minimum term of 90 days and a
maximum term of five years.
When the actual Interest Rate falls below the Floor Strike Rate the Bank will
reimburse the extra interest to the customer.
Is there a minimum amount for an Interest Rate Floor?
We will be pleased to quote on Interest Rate Floor of $1,000,000 or more.
Q. What happens if I require my funds early? Can I cancel the Floor?
Interest Rate Floors are totally separate to your investment (you may have even
invested with another institution and entered into an Interest Rate Floor with
St.George). If at any time you recall your investment, you can either let the Floor run
to maturity or you may terminate it.
Depending on interest rate movements there may be some remaining value of the
Floor. The Bank will pay this remaining value to you on termination.

Are there any risks associated with an Interest Rate Floor?

There are no risks associated with an Interest Rate Floor. It is important to
understand that if interest rates do not fall below the Floor rate, you have not
obtained any benefit from the purchase of the Floor.
What other information is required?
If you decide you can benefit from an Interest Rate Floor you will be required to sign
the Bank's standard terms and conditions. These documents are easy to read as they
have been written in plain English. They summarise the terms and conditions under
which you agree to deal with the Bank.