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What is an interest rate cap?

Protection from rising rates

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An interest rate cap acts like insurance against high interest rates.

Caps are typically purchased by borrowers with variable rate loans, as a separate contract to the loan.  The cap protects the borrower against the possibility of interest rates rising above a chosen maximum, the cap rate.

The cap buyer pays a premium for the cap in exchange for extra income when interest rates rise above the cap rate.  The further that rates exceed the cap rate, the greater the extra income from the cap.  The cap income offsets the higher interest cost of the variable loan.

When rates are below the cap rate, the borrower receives no income from the cap but simply pays the lower variable rate.

Borrowers owning interest rate caps have less risk of being unable to meet loan payments when interest rates rise and are correspondingly better placed to pass lenders’ affordability assessments.

The risk of a cap is that the buyer pays a premium for the cap but receives nothing in return, for example if interest rates remain below the cap rate for the duration of the instrument.

How are caps priced?

Factors influencing the cap premium

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For a given interest rate environment, the amount of the cap premium is driven by three variables, the loan amount protected, the duration of the protection and the cap rate.

Amount protected: the larger the amount being protected, the larger the potential pay-out on the cap.  Consequently, the cap premium tends to change in proportion with the amount of loan it is hedging.

Duration:  The longer its duration, the more likely that the cap will pay out and the more expensive the cap.  Generally, each year added to the duration of a cap costs more than the previous year.

Cap rate: the lower the cap rate, the greater the probability that the cap will pay out (and the larger each payment will be).  Accordingly, caps with lower cap rates are more expensive than caps with higher cap rates.

For a given cap structure (amount protected, duration and cap rate) the cost of the cap premium will fluctuate over time based on changes in interest rates and interest rate volatility.

What are the risks of buying a cap?

Loss of premium

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two people discussing the risks of an interest rate caps

The worst that can happen is the buyer pays the premium for the cap but does not receive any payments from it, for example if the interest rate stays below the cap rate for the life of the instrument.

Provided that the cap premium has been paid, there can never be a penalty to exit a cap early.  The cap’s early redemption value will always be positive or zero.  The early redemption value of a cap tends to decline as time passes.

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