An interest-rate agreement is an agreement between two parties whereby one party, for an upfront premium, agrees to compensate the other at specific time periods if a designated interest rate, called the reference rate, is different from a predetermined level. When one party agrees to pay the other when the reference rate exceeds a predetermined level, the agreement is referred to as an interest-rate cap or ceiling. The agreement is referred to as an interest-rate floor when one party agrees to pay the other when the reference rate falls below a predetermined level. The predetermined interest-rate level is called the strike rate.

The terms of an interest-rate agreement include

  1. The reference rate
  2. The strike rate that sets the ceiling or floor
  3. The length of the agreement
  4. The frequency of settlement
  5. The notional principal amount

Suppose that C buys an interest-rate cap from D with terms as follows:

Funds

  1. The reference rate is six-month LIBOR
  2. The strike rate is 8%
  3. The agreement is for seven years
  4. Settlement is every six months
  5. The notional principal amount is $20 million

Under this agreement, every six months for the next seven years, D will pay C whenever six-month LIBOR exceeds 8%. The payment will equal the dollar value of the difference between six-month LIBOR and 8% times the notional principal amount divided by 2. For example, if six months from now six-month LIBOR is 11%, D will pay C 3% (11% minus 8%) times $20 million divided by 2, or $300,000. If six-month LIBOR is 8% or less, D does not have to pay anything to C.

In the case of an interest-rate floor, assume the same terms as those for the interest- rate cap we just illustrated. In this case, if six-month LIBOR is 11%, C receives nothing from D, but if six-month LIBOR is less than 8%, D compensates C for the difference, For example, if six-month LIBOR is 7%, D will pay C $100,000 (8% minus 7% times $20 million divided by 2).

Interest-rate caps and floors can be combined to create an interest-rate collar. This is done by buying an interest-rate cap and selling an interest-rate floor. Some commercial banks and investment banking firms write options on interest-rate agreements for customers. Options on caps are captions; options on floors are called flotions.

Risk/Return Characteristics

In an interest-rate agreement, the buyer pays an upfront fee, which represents the maximum amount that the buyer can lose and the maximum amount that the writer of the agreement can gain. The only party that is required to perform is the writer of the interest-rate agreement. The buyer of an interest-rate cap benefits if the underlying interest rate rises above the strike rate because the seller (writer) must compensate the buyer. The buyer of an interest rate floor benefits if the interest rate falls below the strike rate, because the seller (writer) must compensate the buyer.

To better understand interest-rate caps and floors, we can look at them as in essence equivalent to a package of interest-rate options. Because the buyer benefits if the interest rate rises above the strike rate, an interest-rate cap is similar to purchasing a package of call options on an interest rate or purchasing a put option on a bond. The seller of an interest-rate cap has effectively sold a package of call options on an interest rate or sold a package of put options on a bond. The buyer of an interest-rate floor benefits from a decline in the interest rate below the strike rate. Therefore, the buyer of an interest-rate floor has effectively bought a package of put options on an interest rate or a package of call options on a bond from the writer of the option.

Once again, a complex contract can be seen to be a package of basic contracts, or options in the case of interest-rate agreements. Captions and flotions can be viewed as options on a package of options.

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Interest-Rate Agreements (CAPS AND FLOORS)