How Banks Price Interest Rate Caps & Floors
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What is an Interest Rate Cap?
An Interest Rate Cap (‘Cap’) is a tool for managing interest rate exposure (SONIA, Libor or Euribor) on your loan. In many respects it is similar to purchasing an insurance product for your home or car. This is because the buyer of an Interest Cap Rate receives a pay-out, in return for a non-refundable Premium payment, if a loss event occurs. However, rather than an accident or a theft, the loss event with an Interest Rate Cap occurs when interest rates increase above a maximum rate, known as the Strike Rate. In this paper, we provide you with a product profile of this increasingly popular risk management product. We discuss how interest rate caps and interest rate floors work, and how costly an inadequate interest rate cap profile can be.
What determines the cost of an interest rate cap?
Caps can be tailored to suit your specific requirements. You can customise a Cap to lower the premium by varying some or all the following terms:
- · Notional Amount: The Principal loan amount – the amount of the loan you’re looking to hedge with a cap. This can be set to a constant amount over the Term or can vary. Cap pricing tends to change linearly with notional.
- · Strike rate: The strike rate defines the interest rate at which the cap provider begins to make payments to the cap purchaser. As a result, lower strike caps are more expensive than higher strike caps.
- · Term / Maturity Date: This is the length of time the cap is protecting the borrower. The longer the term, the more expensive the cap.
- · Interest Payment frequency: Selecting shorter dated payment frequencies like quarterly over semi-annually can reduce the cost.
- · Floating Reference Rate: Today there are huge variances between the cost of hedging US dollars debt (SOFR) compared to SONIA for sterling loans and Euribor for euro loans.
Features of an interest Rate Cap
Caps provide protection against upward interest rate movements above the Strike Rate. While they also allow you to benefit fully from lower interest rates below the Strike Rate. This allows you to better manage your cash flow management and budgeting. To assist, we conduct stress test analysis to determine where your optimum strike rate should be.
Caps are flexible interest rate management tools and can be tailored to suit your specific requirements. You can customise a Cap by varying some or all the following terms.
- · Preferred Interest Rate Strike: The Interest Rate Strike can be positioned to reflect the level of protection you seek. This protection can be prescriptive and set by the lender in their loan documentation. Or it can driven by you based on a stress test of loan covenants, return metrics or simply the amount of Premium you are willing to pay.
- · Effective Date / Start Date: Future dated start dates are generally more expensive depending on the curve.
While an interest rate Cap is used to control the cost of interest on a Loan, it is a separate agreement and is not tied to a specific facility. As a result, it can be used to hedge a portfolio of loans with one or more Lenders. If a Loan is repaid early, it may be possible for you to retain the Cap to hedge a different Loan.
It may be possible to novate (i.e., transfer) a Cap to another entity or another Hedging Bank, subject to credit approval. This can be useful if the credit rating of your Hedging Bank falls below a rating threshold.
You can also terminate the product during the life of the Cap, at prevailing market rates. If you have paid the Premium up-front, there is normally no cost to terminate but you may receive a benefit if the Cap has a positive value.
What are the risks associated with an Interest Rate Cap?
If the reference rate remains at or below the Strike rate for the duration of the Cap, your Cap will expire unutilised and your Interest Rate Premium will not be refunded. The good news is that you will have enjoyed a low interest rate environment!
While normally there is no cost to terminate a Cap early (if you pay the Interest Rate Premium up-front). You may incur costs if you need to amend the Cap during the term of cover. Given this risk, it is important that you carefully consider the key terms of your Cap at the time of trading.
By entering a Cap with a Hedging Bank, you have an exposure to the Hedging Bank for the duration of the hedge. It is vital you choose the correct counterparty as the term of a Cap can run for many years.
What is the on-boarding timeframe?
Getting approval to trade with a Hedging Bank can be a quite laborious process. There are the usual Know your Customer (KYC) and anti-money laundering processes that need to be completed before you open any account with a financial institution. However, there are also additional processes that need to be completed as Cap transactions need to comply with a raft of international tax and derivative regulatory legislation as well as investor protection requirements.
The onboarding processes of all Hedging Banks will need to address these areas. While some documentation will be consistent across all banks. The information requirements of different Hedging Banks is highly variable and can be time-consuming to complete. Finally, while a full ISDA agreement is not usually required for Cap transactions. The contract underpinning the Cap, a Long Form Confirmation, will need to be negotiated prior to trading.
At Vuca Treasury, it is our experience that this whole process can take a number of weeks to complete. We strongly advise that borrowers begin this process early if a Cap is a condition of a Loan. If your Lender does not have the ability to provide you with the Cap then this process should start asap.
How much does an Interest Rate Cap Cost
The Premium is calculated at the time you purchase the Cap. To calculate the Premium of an interest rate cap rate, several factors are considered depending on the interest rate cap structure, including;
- · Strike Rate (the lower the Strike, the higher the Premium)
- · Notional Loan Amount (the higher the Loan Principal amount you are protecting, the higher the Premium)
- · Term of Cover (Premium increases with the term you are seeking cover for)
- · Current and expected future market interest rates (higher rates increase the probability of a pay-out and lead to higher Premium)
How does an Interest Rate Cap work
Typically, at the beginning of each interest period (on each Reset Date), the Reference Rate will be set. This rate is compared to the Strike Rate. If the Reference Rate is below the Strike Rate, no payment is due. However, if the Reference Rate is above the Strike Rate, the Hedging Bank will compensate you to offset the higher interest expense you have incurred on your loan. Although this payment is calculated at the start of the interest period, it is paid by the Hedging Bank at the end of the period.
The formula to determine the payment for Sterling Caps is:
(Reference Rate – Strike Rate) * Notional Loan Amount * (days in interest period/365)
The formula to determine the payment for Euro Caps is:
(Reference Rate – Strike Rate) * Notional Loan Amount * (days in interest period/360)
To summarise, your effective interest rate for the period will be the lower of the Reference Rate or the Strike Rate (excluding any fees and margins payable under your loan agreement). An example under 3 difference scenarios is provided in the table below (a 10 million loan for a quarter (0.25) of a year):
Interest Rate Cap and Floor Confirmations
Post transaction, your Hedging Bank will send you a Confirmation outlining the relevant commercial terms of the transaction. It is important you check the Confirmation to make sure that it matches your understanding of the trade. This should be received within 1-2 days of the transaction date and needs to be signed by both parties.
How Vuca Treasury can help?
As an independent and unbiased treasury consultancy, Vuca Treasury’s mission is to ensure that our clients make informed decisions. As practitioners with multi-decade experience in the financial and capital market divisions of major global banks, we have the inside track on how banks structure and price derivatives. We leverage this insight to ensure that our clients get the most competitive terms when they look to buy an Interest Rate Cap.
We manage the whole trade lifecycle. From selecting and onboarding you as a client with the Hedging Banks that we identify as offering you the optimal combination of price and security. To negotiating and benchmarking the Cap transaction itself. Finally we provide whatever post-trade support that you need over the term of the Cap.
To find out more, please contact us at email@example.com