The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

INTEREST RATE AGREEMENTS (CAPS AND FLOORS)

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 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 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.

For example, suppose that C buys an interest rate cap from D with terms as follows:

1. The reference rate is three-month LIBOR.

2. The strike rate is 6%.

3. The agreement is for four years.

4. Settlement is every three months.

5. The notional principal is $20 million.

Under this agreement, every three months for the next four years, D will pay C whenever three-month LIBOR exceeds 6% at a settlement date. The payment will equal the dollar value of the difference between three-month LIBOR and 6% times the notional principal divided by 4. For example, if three months from now three-month LIBOR on a settlement date is 8%, then D will pay C 2% (8% ...