Cap

What Is Cap?

In finance, a cap, specifically an interest rate cap, is a type of derivative contract that provides the buyer with protection against rising interest rates. It falls under the broader category of interest rate derivatives within financial instruments. A cap sets a maximum level, known as the strike price, on a variable or floating rate loan. If the underlying reference interest rate—such as LIBOR (London Interbank Offered Rate) or SOFR (Secured Overnight Financing Rate)—exceeds this strike price, the seller of the cap compensates the buyer for the difference. This effectively "caps" the borrower's interest payments at a predetermined maximum, limiting their exposure to upward fluctuations in interest rates.

History and Origin

The concept of derivatives has roots extending back centuries, with early forms emerging to manage risks in commodities like rice and agricultural products. However, modern financial derivatives, including those based on interest rates, began to take shape more recently. Interest rate derivatives, which include instruments like caps, floors, and swaps, became indispensable tools for risk management on financial markets following their introduction in the late 1970s. Key milestones in the development of these instruments include the launch of financial futures contracts by the Chicago Mercantile Exchange in 1972 and the introduction of the first interest rate futures contracts by the Chicago Board of Trade in 1975.,

T³h²e growth of the over-the-counter (OTC) market for interest rate derivatives has been significant, driven by factors such as technological advancements reducing transaction costs and increased demand for hedging and speculative activity amidst interest rate uncertainty.

##¹ Key Takeaways

• An interest rate cap protects borrowers against increases in variable interest rates by setting a maximum rate.
• If the market interest rate rises above the cap's strike price, the cap seller pays the difference to the buyer.
• Caps are a form of interest rate derivative used for hedging interest rate risk.
• The cost of a cap is paid upfront as a premium.
• A cap allows the buyer to benefit if interest rates fall, while providing a ceiling if they rise.

Formula and Calculation

An interest rate cap can be analyzed as a series of call options, known as "caplets," with each caplet corresponding to a specific interest period. The payoff from a caplet occurs when the reference interest rate exceeds the strike price. The payment for a period is calculated as:

Where:

• Notional Amount is the principal amount on which the interest rate payments are calculated, though it is not exchanged. It represents the hypothetical loan amount being hedged.
• Reference Rate is the prevailing market interest rate (e.g., SOFR) for the period.
• Strike Rate is the agreed-upon maximum interest rate specified in the cap agreement.
• Days in Period refers to the number of days in the interest accrual period. The division by 360 or 365 depends on the specific day count convention for the underlying rate.

The "Max(0, ...)" ensures that a payment is only made if the reference rate is above the strike rate.

Interpreting the Cap

A cap is interpreted as an insurance policy against rising interest costs. When a borrower purchases a cap, they are essentially buying peace of mind regarding their potential future interest payments on a floating rate loan. The lower the strike price relative to the current market rate, or the longer the term, generally the higher the premium will be, reflecting a greater likelihood or duration of payouts. Conversely, a cap with a higher strike rate is cheaper because the probability of the market rate exceeding it is lower. The decision to purchase a cap often reflects a borrower's outlook on future interest rates and their comfort level with potential increases in their debt service costs.

Hypothetical Example

Consider "Company A," which has a five-year loan with a notional amount of $10 million, indexed to SOFR plus a spread of 1%. To manage their interest rate risk, Company A purchases an interest rate cap with a 3% strike price on the SOFR component.

If, during an interest period, SOFR rises to 3.5%, here's how the cap would function:

• The loan's effective SOFR component without the cap would be 3.5%.
• With the cap, the strike price of 3% is exceeded by 0.5% (3.5% - 3.0%).
• The cap provider would pay Company A the difference of 0.5% on the $10 million notional amount for that period (adjusted for days).
• Company A still pays its lender based on the 3.5% SOFR, but the payment from the cap offsets the portion of interest above 3%, effectively limiting their net interest cost (excluding the initial cap premium) to a SOFR component of 3%.

Practical Applications

Interest rate caps are widely used by borrowers with variable-rate debt to manage their exposure to rising interest rates. This includes:

• Commercial Real Estate Financing: Developers and investors often use caps to protect against increased debt service payments on floating-rate mortgages, which are common for construction loans or bridge financing.
• Corporate Debt: Companies with significant variable-rate corporate bonds or lines of credit utilize caps to stabilize their borrowing costs and provide predictability for cash flow planning.
• Project Finance: Large-scale projects with long amortization periods frequently employ caps as part of their overall risk management strategy.
• Consumer Lending (indirectly): While less common for individual consumers to buy caps directly, the principle can underpin certain structured financial products offered to consumers, or be used by lenders to manage their own portfolio risk from variable-rate loans.

The transition from LIBOR to alternative reference rates like SOFR has significantly impacted the market for interest rate derivatives, including caps. Financial institutions and borrowers alike have had to adapt to these new benchmarks, with the Federal Reserve playing a key role in facilitating the transition to SOFR as a robust alternative. New York Fed SOFR Page

Limitations and Criticisms

While providing valuable hedging benefits, interest rate caps do have limitations. One primary drawback is the upfront cost, or premium, which must be paid by the buyer regardless of whether the cap pays out. Unlike an interest rate swap that might involve ongoing payments or receipts, a cap is similar to an insurance policy where the benefit only materializes if the undesirable event (rate increase above the strike price) occurs.

From a market perspective, caps are sometimes underutilized compared to interest rate swaps, partly because banks may earn higher profit margins from selling swaps. Additionally, borrowers may be reluctant to pay the upfront fee, even if it could lead to long-term savings or protection against substantial interest rate risk. This aversion to upfront costs, even for "disaster protection," can lead borrowers to overlook caps. DerivGroup White Paper

Another consideration is basis risk. If the reference rate of the loan differs from the reference rate of the cap (e.g., a loan indexed to a bank's prime rate versus a cap indexed to SOFR), the protection offered by the cap may not perfectly align with the actual interest costs of the loan, leaving some residual exposure.

Cap vs. Floor

The terms "cap" and "floor" in the context of interest rate derivatives represent inverse concepts, both designed to manage interest rate risk.

An interest rate cap protects the buyer from rising interest rates. It sets a maximum rate, and if the market rate exceeds this cap, the seller pays the buyer the difference. The buyer benefits from falling rates but is protected from rates that increase too much.

An interest rate floor, conversely, protects the buyer from falling interest rates. It sets a minimum rate, and if the market rate falls below this floor, the seller pays the buyer the difference. A floor is typically purchased by an investor or lender who receives floating-rate income and wants to ensure a minimum return, protecting against the downside of declining rates.

Both are types of financial instrument used in risk management, but they address opposite directional risks in a variable interest rate environment.

FAQs

How does a cap differ from a fixed-rate loan?

A cap allows a borrower with a floating rate loan to retain the benefit of falling interest rates while providing a ceiling on how high their rates can go. A fixed-rate loan, on the other hand, locks in the interest rate for the entire loan term, meaning the borrower neither benefits from falling rates nor is exposed to rising rates. A cap offers flexibility that a purely fixed-rate loan does not.

Who typically sells interest rate caps?

Interest rate caps are most commonly sold by large financial institutions, such as commercial banks or investment banks. These institutions act as market makers, providing liquidity and taking on the interest rate risk associated with selling these derivatives.

Is the premium for a cap refundable?

No, the premium paid for an interest rate cap is a one-time, non-refundable cost, similar to an insurance premium. It is the cost of acquiring the protection against rising interest rates for the specified term of the cap. Whether the cap "pays out" or not, the initial premium is not returned to the buyer.