CFM13340 - Understanding corporate finance: derivative contracts: interest rate caps and floors
In the example at CFM13300, it is assumed that the interest rate on the two-year loan will be fixed at the outset and will not subsequently vary. It is more likely in practice that the interest rate on the loan will be reset at the end of each month, quarter, half-year or year. A company can still use an option product to hedge its interest rate risk in these circumstances. It can buy what is called an interest rate cap.
A cap consists of a series, or strip, of cash-settled options which can be exercised sequentially on set dates. The effect is that the company is guaranteed a maximum cost for its borrowing, but can still profit from a reduction in interest rates. A premium is payable.
Sherflatt Ltd, an expanding unquoted company, arranges a £4 million 5-year loan from its bank in order to develop the business. The interest terms are 6-month LIBOR plus 0.5%, resetting every 6 months and payable in arrears. Funding costs are critical to the company's business projections, and it does not want to have to pay more than 6.0%. But it anticipates that, in the medium to long term, interest rates will fall, and it does not want to be locked into a 6% rate. At the start of the loan, 6-month LIBOR is 5%, so it is paying 5.5%.
The company buys an interest rate cap from a bank (probably, but not necessarily, the bank advancing the loan), fixing the maximum borrowing rate at 6.0%. It pays the premium quoted by the bank. (This would usually be quoted as a percentage of the face value of the cap, £4 million.)
At the end of 6 months, LIBOR is 5.75%, so Sherflatt Ltd would pay 6.25% for its loan. It exercises its option, and the bank pays
(6.25% - 6.0%) x £4,000,000 x 6/12 = £5,000
so that the company is effectively paying interest at 6%.
At the end of 12 months, the interest rate on the company's loan falls to 5.8%. The company therefore does not exercise its option, and borrows at 5.8% - and so on ... up to the end of the 5 years.
An interest rate floor is a similar option product which allows an investor to hedge a deposit by being guaranteed a minimum rate of interest. In return for a premium, the option holder has the right, but not the obligation, to fix the interest rate on a notional deposit. The option is exercisable at agreed intervals, and is cash settled in the same way as an interest rate cap.