Interest Rate Cap

<body onLoad="MM_checkPlugin('Shockwave Flash','','http://www.riskglossary.com/default_nofl.htm',false);return document.MM_returnValue" stylesrc="../_private/template.htm" bgcolor="#FFFFFF" link="#669933" vlink="#000000" alink="#000000"> <div align="left"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table1"> <tr> <td width="740"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" height="37" id="table2"> <tr> <td height="35" width="100%"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" id="table3"> <tr> <td width="100%" align="left" valign="top"> <p class="header_gold">Interest Rate Cap</td> <td width="45" align="right" valign="bottom"> <map name="FPMap6"> <area href="http://www.contingencyanalysis.com" shape="rect" coords="1, 0, 44, 11" target="_top"> </map> <img border="0" src="../images/home.gif" usemap="#FPMap6" width="45" height="12"></td> </tr> </table> </td> </tr> <tr> <td width="100%" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td width="0%" valign="top" bgcolor="#FFFFCC"> <table border="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" cellspacing="1" id="table4"> <tr> <td width="0%" align="left" valign="top"> <p class="header2_black">Explained:<br> <img border="0" src="../images/blank_1x100.gif" width="100" height="1"></td> <td width="0%" align="left" valign="top"><p class="word_list"> <a href="#caplets">caplet</a><p class="word_list"> <a href="#interest-rate cap">interest-rate cap</a><br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> <td width="100%" align="left" valign="top"><p class="word_list"> <br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> </tr> </table> </td> </tr> </table> <table border="0" cellpadding="0" style="border-collapse: collapse" bordercolor="#111111" width="310" align="right" id="table5"> <tr> <td align="right" width="9" height="14"></td> <td width="300" height="14"> <font size="2"> </font><font size="4"> </font></td> </tr> <tr> <td align="right" width="9"> </td> <td width="300"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> </tr> </table> <p class="body">An <b><a name="interest-rate cap">interest-rate cap</a></b> is an <a href="../articles/exchange_traded.htm">OTC</a> <a href="../articles/derivative_instrument.htm">derivative</a> that protects the holder from rises in short-term interest rates by making a payment to the holder when an <a href="../articles/derivative_instrument.htm">underlying</a> interest rate (the "index" or "reference" interest rate) exceeds a specified <a href="../articles/option.htm">strike</a> rate (the "cap rate"). Caps are purchased for a <a href="../articles/option.htm">premium</a> and typically have expirations between 1 and 7 years. They may make payments to the holder on a monthly, quarterly or semiannual basis, with the period generally set equal to the maturity of the index interest rate. </p> <p class="body">Each period, the payment is determined by comparing the current level of the index interest rate with the cap rate. If the index rate exceeds the cap rate, the payment is based upon the difference between the two rates, the length of the period, and the contract's <a href="../articles/notional_amount.htm">notional amount</a>. Otherwise, no payment is made for that period. If a payment is due on a <a href="../articles/currency_codes.htm">USD</a> <a href="../articles/libor.htm">Libor</a> cap, it is calculated as</p> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" height="36" id="table6"> <tr> <td width="100%" align="center"> <img border="0" src="../formulas/cap_payment_calculation.gif" width="339" height="44"></td> <td width="5%" align="right">[1]</td> </tr> </table> <p class="body">For example, Exhibit 1 illustrates a 3-year, USD 200<a href="../articles/mm.htm">MM</a> notional cap with 6-month Libor as its index rate, struck at 7.5%. The exhibit shows what the cap's payments would be under a hypothetical interest rate scenario. </p> <div align="center"> <center> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="350" cellpadding="0" id="table7"> <tr> <td> <p class="exhibit_header"><span class="exhibit_header">Example: Cap Payments</span><br> <span class="exhibit_subheader">Exhibit 1</span></td> </tr> <tr> <td bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td><img border="0" src="../formulas/ex1_cap.gif" width="300" height="128"></td> </tr> <tr> <td> <p class="exhibit_legend">Payments made under a hypothetical interest rate scenario by a 3-year USD 200MM notional cap linked to 6-month USD Libor with strike rate of 7.5%. Values for the index rate are 6.25%, 7.75%, 7.00%, 8.50%, 8.00%, and 6.25%. These result in payments of USD 0MM, USD .25MM, USD 0MM, USD 1MM, USD .5MM, and USD 0MM.</td> </tr> </table> </center> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="345" align="right" id="table8"> <tr> <td align="right" width="9" height="10"></td> <td width="336" height="10"> <font size="2"> </font></td> </tr> <tr> <td align="right" width="9"> </td> <td width="336"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> </tr> </table> <p class="body" style="margin-top: 16" align="left">Caps are frequently purchased by issuers of <a href="../articles/floater.htm">floating rate debt</a> who wish to protect themselves from the increased financing costs that would result from a rise in interest rates. To reduce the up-front cost of such protection, a <a href="../articles/short_sale.htm">long</a> cap may be combined with a <a href="../articles/short_sale.htm">short</a> <a href="../articles/floor.htm">floor</a> to form a <a href="../articles/options_spread.htm">collar</a>.</p> <center> <p class="body" align="left">A cap can be thought of as a series of interest rate options called <b><a name="caplets">caplets</a></b>. Caps are priced by valuing the individual caplets and summing the values. The <a href="../articles/black_1976.htm">Black '76</a> option pricing formula is the market convention for quoting <a href="../articles/volatility.htm">implied volatilities</a> for caps. </p> <center> <p class="body" align="left">Caps are usually quoted with an up-front premium. If they are quoted with an implied volatility, it is with a flat implied volatility across all caplets.</p> </center> </center> </div> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table9"> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Related Internal Links</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table10"> <tr> <td width="100%"> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><span class="verdana10"><strong style="font-weight: 400"><a href="../articles/asset_liability_management.htm">asset-liability management</a></strong></span><strong style="font-weight: 400"> Techniques for protecting a firm's solvency in the context of accrual accounting.</strong><p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/black_1976.htm">Black (1976) option pricing formula</a> Used to price caps, among other things.<p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/derivative_instrument.htm"><strong style="FONT-WEIGHT: 400">derivative instrument</strong></a><strong style="FONT-WEIGHT: 400"> An instrument which derives its value from the value of other financial instruments. 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