Rate Limiting Tools: Interest Rate Caps, Floors and Collars
Caps and floors are essential tools in managing floating rate liabilities while minimizing hedging and opportunity costs. They protect against adverse rates risk, while allowing gains from favourable rate movements. Caps and floors are forms of option contracts, conferring potential benefits to the purchaser and potential obligations on the seller. When purchasing a cap or floor, the buyer pays a premium- typically up-front. The premium amount depends on the specified cap or floor rate and time period covered, which may range from a few months to several years.
Benefits of Caps, Floors and Collars
Caps and floors greatly enhance a treasurer's flexibility in managing financial assets and liabilities. Used together or in combination with other hedging instruments, caps and floors are efficient tools for reconfiguring a company's financial risk profile.
Caps and floors are used to:
- Hedge floating-rate liabilities
- Reduce borrowing costs
- Increase investment returns
- Create synthetic investments
- Neutralize options embedded in assets or liabilities
Interest Rate Caps
A cap creates a ceiling on floating rate interest costs. When market rates move above the cap rate, the seller pays the purchaser the difference. A company borrowing on a floating rate basis when 3 month LIBOR is 6% might purchase a 7% cap, for example, to protect against a rate rise above that level. If rates subsequently rise to 9%, the company receives a 2% cap payment to compensate for the rise in market rates. The cap ensures that the borrower's interest rate costs will never exceed the cap rate.
Interest Rate Floors
A floor is the mirror image of a cap. When market rates fall below the floor rate, the seller pays the difference. A 6% floor triggers a payment to the purchaser whenever market rates drop below 6%. Asset managers buy floors to guarantee a minimum return on floating rate assets. They sell floors to generate incrementally higher returns. Debt managers buy floors to protect against opportunity losses on fixed rate debt when rates fall. They may sell floors as a component of a hedge strategy involving other derivative instruments.
Combining Caps and Floors to Create Collars
A collar is created by purchasing a cap or floor and selling the other. The premium due for the cap (floor) is partially offset by the premium received for the floor (cap), making the collar an effective way to hedge rate risk at low cost. In return the hedger gives up the potential benefit of favourable rate movements outside the band defined by the collar. A borrower who purchases an 8% cap and sells a 6% floor guarantees a 6-8% base rate on a floating rate loan. An investor in floating rate CD's might do exactly the opposite, buying a 6% floor and financing it with the sale of an 8% cap. A costless collar is created when the cap and floor levels are set so that the premiums exactly offset each other.
Caps, floors and collars are a simple but very effective way to control risk and manage hedge costs. The option characteristics of caps and floors offer unique opportunities to minimize borrowing costs or achieve higher investment returns.