A low interest rate is a relatively inexpensive interest rate management strategy that uses derivatives to ensure an investor`s exposure to interest rate fluctuations. An interest rate cap uses interest bonus contracts to protect a borrower from rising interest rates, while capping interest rates down. An interest rate limit allows variable rate investors to maintain the upside benefits of their variable rate investment while maintaining the comfort of a known minimum interest rate. Let`s get back to the borrower! They set a maximum rate, but the downside is that they have to pay the premium. Caps based on a base interest rate (such as a constant maturity swap) cannot be evaluated with the simple techniques described above. The evaluation methodology for CMS Caps and Floors can be referenced in more advanced documents. Sir John, I have a question on the issue of the “Armstrong Group” which was published in document Sept/Dec 15. The solution says we buy the December call at 97.00 and sell December at 96.50 (we are an investor in the issue). I don`t understand the logic. Wouldn`t it be more risky to buy a ceiling of at least 3.5% instead of 3.0% (we earn 0.5% if interest rates fall). and sell the option holder at 3.0% (we will save 0.5% if interest drops)? Please help me understand the reasons for what the solution offers.
How do we choose to use the rate for the cap and floor option? Thank you in advance! An interest cap sets a cap on interest payments. It is simply a series of call options on a floating interest rate index, usually 3 or 6 months-London Interbank Offered Rate (LIBOR), which coincides with rollover dates on the borrower`s variable liability. The exercise price or strike rate of these options represents the maximum interest rate to be paid by the purchaser of the cap. If real interest rates for borrowers rise above the strike cap rate, St.George will refund the additional interest. If the real interest rate falls below the floor strike rate, you can pay back st. George the extra interest. The cost of the cap is called a premium. The premium for an interest rate cap depends on the guarantee rate you want to achieve relative to current market rates.
For example, if the market`s current interest rates were 6%, you would pay a ceiling of 7% more than a ceiling of 8.5%. The premium for an interest rate cap also depends on how often you rollover and how you pay your premiums.