Interest Rate Cap
In a volatile interest rate market, it can be challenging to predict how high or how quickly interest rates will rise, leaving your project with some uncertainty in the budget.
An interest rate cap can be an ideal hedging instrument for a client who wants to protect themselves against rising interest rates while still having the ability to take advantage of falling interest rates. In exchange for an upfront premium, a client can "Cap" the interest rate exposure at a predetermined strike while paying lower interest rates while market rates reset below the cap rate. With a cap in place, the client has the security of a known maximum interest rate payment.
At each drawdown or rollover date, the capped rate is compared with the applicable LIBOR (London Interbank Offered Rate). 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.
Graph: The red points show the months in which the cap buyer is using the protection of the cap.In these months, the interest rate being paid is "capped" at 4.000%, even though the prevailing market interest rate is higher. In each month, the cap buyer will pay the minimum of either the cap rate or the market rate of interest.
Our Interest Rate Risk Management team would be happy to discuss your requirements.
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