6116 - 16.15 - Interest rate caps - FINAL - Hogeschool-Universiteit Brussel Campus Stormstraat Finance Interest Rate CAPS Master Business Administration

6116 - 16.15 - Interest rate caps - FINAL -...

This preview shows page 1 - 5 out of 13 pages.

Hogeschool-Universiteit Brussel Campus Stormstraat Finance Interest Rate CAPS Master Business Administration 4AE Academic Year: 2009-2010 Kseniia Sylka Olesia Sorokina Diana Stancevic Ana Bairac Coordinator: Bart Vinck Brussels 2009 1
Image of page 1
Hogeschool-Universiteit Brussel Campus Stormstraat Finance Contents 1. Introduction into Interest Rate CAPS………………………….3 2. Pricing formalism of the IRC...…………………………….….6 3. Excel tool development………………………………………..9 4. References…………………………………………………….12 2
Image of page 2
Hogeschool-Universiteit Brussel Campus Stormstraat Finance 1 INTRODUCTION INTO INTEREST RATE CAPS In a volatile interest rate market, it can be challenging to predict how high or how quickly interest rates will rise, leaving projects with some uncertainty in the budget. An interest rate ‘Cap’ can be an ideal hedging instrument for clients who want to protect themselves against rising interest rates while still having the ability to take advantage of falling interest rates. An interest rate ‘Cap’ is a derivative that seeks to protect investors from higher interest rates in the future. Investors purchase a ‘Cap’, select a maximum level of interest rates (this maximum interest rate is known as the Strike Rate) and for a specified term, agree to a schedule of Reset Dates. These are the dates that bills of exchange will be drawn or rolled under underlying variable rate bank bill facility (for example, bills could drawn/rolled on a 30, 60 or 90 day basis). The time between resets is known as the caplet maturity. In return investors shall receive a series of quarterly payments once market interest rates exceed the selected ‘Cap’ level. With a cap in place, the client has the security of a known maximum interest rate payment. The Reference Rate to be used is also set at the beginning of the transaction. The Reference Rate provides a benchmark interest rate. The commonly used reference rate is LIBOR (London Interbank Offered Rate). At each drawdown or rollover date, the capped rate is compared with the applicable LIBOR. If LIBOR is lower than the cap rate, the client pays the LIBOR rate for that rollover period. If LIBOR resets higher than the cap rate, the bank compensates the client the difference between LIBOR and the cap rate for that rollover period. Like swaps, interest rate caps can be tailored to match the terms of the underlying loan. The premium or cost of the cap is calculated and paid for upfront. This can be paid as a one-off up front premium or, with the bank approval, it can be amortized over the term of 3
Image of page 3
Hogeschool-Universiteit Brussel Campus Stormstraat Finance the cap. This may incur an extra charge. The drivers of the cost are the term of the cover and the level of the interest rate selected. The longer the term of the cover the more expensive the Cap, and the lower the interest rate the more expensive the premium.
Image of page 4
Image of page 5

You've reached the end of your free preview.

Want to read all 13 pages?

  • Left Quote Icon

    Student Picture

  • Left Quote Icon

    Student Picture

  • Left Quote Icon

    Student Picture

Stuck? We have tutors online 24/7 who can help you get unstuck.
A+ icon
Ask Expert Tutors You can ask You can ask You can ask (will expire )
Answers in as fast as 15 minutes