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Interest Rate Cap

What is an Interest Rate Cap?

An Interest Rate Cap is a contractual agreement between two counterparties, the Borrower, which is the buyer, and the Bank, which is the seller. The Bank agrees to insure the Borrower against a rise in the floating rate of interest (i.e. three month LIBOR) above an agreed strike rate. In exchange for the Cap, the Borrower is required to pay a cash premium to the Bank, usually upfront.

Objectives

The purpose of the Cap is to establish a maximum cost of finance for the Borrower that has floating rate borrowings. This will enable the Borrower to enjoy the benefit of low short-term interest rates until such a time that they rise above the pre-agreed Cap strike rate.

How does it work?

On each three monthly reset date, the Cap strike rate will be compared with the contracted floating rate. If the relevant floating rate is equal to or below the Cap strike rate, no payment will be made. However, if the contracted floating rate is above the Cap strike rate, the Bank will pay the Borrower the difference between the floating rate and the strike rate of the Cap.

Advantages
  • It provides the Borrower with a pre-agreed maximum rate of interest
  • It provides the Borrower with the flexibility to benefit from low floating rates, should they be lower than the Cap strike rate
  • There are no additional costs arising from early termination. The Borrower will be entitled to receive any residual value attributable to the Cap
Disadvantages
  • The Borrower will incur a premium cost, usually paid up front
  • If the floating rate fails to rise above the Cap strike rate during the tenor of the Cap, the Borrower may feel that no value was received

Interest rate cap example:

 

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