Purpose Of Interest Rate Cap
The purchase of a Cap will allow the borrower to fix a maximum interest rate for one or more future money market loans (short-term or roll-over loans) thus protecting it against rising interest rates.
What is Interest Rate Cap?
Its an option contract between two parties regarding money market interest rate. This contract concerns an agreed principal and an agreed series of interest periods. This will be against a payment of a premium that will be paid in advance.
The buyer of the Cap option agreement will guarantee a maximum of an agreed interest rate from the seller.
At the start of each agreed interest period, The agreed Cap rate is compared with the money market interest rate(MMR) applicable at that time (e.g. Libor). If the MMR is higher, then CAP agreed rate. Terrastone Financial Services will pay the difference to the buyer (Client) at the end of the interest period. If MMR is lower, then CAP agreed rate, no settlement takes place.
It can be arranged for a series of interest rates payable in the future (e.g. on short-term or roll-over loans)
It’s exclusively relates to an interest rate difference to be settled and is separate from underlying principal transaction.
The market values of the bought interest Rate Cap can either rise or fall, but will never become negative.
An Example of Interest Rate Cap
Company has a loan roll-over at (LIBOR+1% margin) with a remaining term to maturity 5 years. Assuming the current market 5 years interest rate is 5% and current LIBOR is 3%.
Company can fix or Cap its interest rate on the current loan at 6% (Five years rate 5% + Margin 1%) for the remaining loan term (five years). With expectations of MMR to remain low for long time and keen to take advantage of this. Also the aim is rule out the risk of financing costs rising above 7% yearly if interest outlook proves mistaken. Company decides to buy a Cap at 6% for five years maximizing the interest charges plus 1% margin to 7%. This will be excluding the premium payable in advance for the Cap agreement.
At this example, premium amounts to 2% (as per market pricing) of the principal. (Plus or Minus 0.70% Annually).
A fixed interest rate of 6% against a variable rate with a Cap is (Cap 6% +Margin 1% + Premium of 0.70% annually) will be 7.70%
If Interest Rates rise sharply:
||Settlement under Cap
||Result With Cap
||Result W/ fixed rate
Cap Risks and Benefits
The borrower buys the Cap to protect himself / herself against an unfavorable rate movements, premium is paid in advance. If rates movements fails to materialize, borrower can see that paid premium as a loss. However borrower can take full advantage of it in case of favorable interest rate movement.
Also, it allows the borrower to put a maximum to interest rate charges of future money market loans. A Cap Option agreement is a customized product. Effective Date, Expiry Date, the Cap agreed rate and frequency of interest rate payment/ receipts can be tailored subject to borrowers’ requirements vision. In addition, it can be arranged for fixed or variable principal sum (to be arranged in advance).
The cost of Buying a Cap are limited, so no further costs or commissions are involved. Also Cap agreement is separate from client underlying loan. No obligations to arrange short-term or roll-over loans with the same banks.
It can be sold in the interim for the then applicable premium.