STOCK GYAN. (Part – 6, Interest Rate Caps & Floors)Atul Khurana
Hope you had read the previous parts of Stock Gyan series, if not then click on the below links:
Part 1: Basics
Part 2: Bonds
Part 3: Loans
Part 5: Interest Rate Swaps
We were discussing about Long term Debt Asset class under which we had discussed about the above 4 grandchilds.
Don’t get confused. Let me remind you this hierarchy again.
In relation to our today’s topic:
- The parent name is Long Term Debt
- The child name is OTC derivatives
- The grandchild names are Interest rate swaps, Interest rate caps and floors, Interest rate options and Exotic derivatives, out of which Interest Rate Caps has already discussed.
Let’s come to the further parts of OTC Derivatives:
Interest rate caps and floors:
- An interest rate cap is a type of interest rate derivative in which the buyer receives payments at the end of each period in which the interest rate exceeds the agreed strike price. An example of a cap would be an agreement to receive a payment for each month the LIBOR rate exceeds 2.5%.
- Similarly an interest rate floor is a derivative contract in which the buyer receives payments at the end of each period in which the interest rate is below the agreed strike price. The buyer of the floor receives money if on the maturity of any of the floorlets, the reference rate is below the agreed strike price of the floor or you can say that in an interest rate floor, the seller agrees to compensate the buyer for a rate falling below the specified rate during the contract period.
- The caps and floors consist of aseries of European interest call & put options (called caplets).
The strike price means the maximum interest rate payable by the purchaser of the cap.
Caps and floors can be used to hedge against interest rate fluctuations as:
- Interest rate caps are used often by borrowers in order to hedge against floating rate risk.
- Interest rate floors are used often by borrowers in order to hedge against falling interest rates.
(Hedge: A hedge is an investment position intended to offset potential losses or gains that may be incurred by a companion investment).
When we talk about Interest Rate caps and floors, then there are two more term which needs to be discussed along with these. The terms are: Interest rate collars and reverse collars.
Let us understand what are these.
Interest rate collars:
An interest rate collar is the simultaneous purchase of an interest rate cap and sale of an interest rate floor on the same index for the same maturity and notional principal amount.
The objective of the buyer of a collar is to protect against rising interest rates.
Let’s break this definition for clear understanding:
Index: It is a measurement of the value of a section of the stock market. It is computed from the prices of selected stocks (typically a weighted average). It is a tool used by investors and financial managers to describe the market, and to compare the return on specific investments.
Notional principal amount: The notional principal amount is the predetermined amounts on which the exchanged interest payments are based. The notional principal never changes hands in the transaction.
Now, in simpler terms, an interest rate collar can be described as buying of an interest rate cap and on the same time, selling the interest rate floor for protecting itself against rising interest rates.
Reverse Interest Rate Collar :
A reverse interest rate collar is the simultaneous purchase of an interest rate floor and simultaneously selling an interest rate cap.
The objective is to protect the buyer from falling interest rates.
Interest rate options
An interest-rate option (IRO) gives the buyer the right to receive a cash payment if market interest rate of a reference rate, usually the LIBOR, specified in the contract, is higher or lower, depending on the option, than the strike rate of the option. The difference amount is settled in cash.
There are two types of contracts: calls and puts.
- A call gives the bearer the right, but not the obligation, to benefit off a rise in interest rates.
- A put gives the bearer the right, but not the obligation, to profit from a decrease in interest rates.
Exotic Derivatives usually refers to more complex, unusual and specific derivative contracts that depend on the value of some underlying asset or defined set of assets. These derivatives are more complex than commonly traded “vanilla” options.
A vanilla option is a financial instrument that gives the holder the right, but not the obligation, to buy or sell an underlying asset, security or currency at a predetermined price within a given timeframe.
Here we ends up all the concepts related to the Long Term Debt Asset class.
In the next, you will study about the Short Term Debt Asset Class Instruments.
So, don’t miss it.
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