1. Caps, Floors, & Collars Copyright 2014 by Diane S. Docking 1 collar

2. Learning Objectives Understand caps, floors, and collars Be able to set up a simple cap, floor, or collar transaction Copyright 2014 by Diane S. Docking 2

3. Cap and Floor Agreements Financial contracts can exist whereby one party agrees to compensate another for the difference between a designated _________________and a pre-determined level, called the ______ ___________ can be an interest rate, currency exchange rate, or even the return on a domestic or foreign stock market index 3

4. Copyright 2014 by Diane S. Docking Interest Rate Cap/Ceiling Agreements A CAP is an agreement where the seller agrees to pay the buyer if the designated reference _________ the strike The Payment or Rebate is given as: Notional Principal Amount x [Actual Value of Reference – Strike] Rebate to buyer = (i index/reference – i cap strike ) x Notional Principal Amount; but only if i index/reference > i cap strike ; else zero. 4

5. Copyright 2014 by Diane S. Docking Interest Rate Cap/Ceiling Agreements (cont.) E.g.: CAP on LIBOR @ 4% If LIBOR t+1 = 5%, then buyer receives (seller pays): (Reference – CAP) x Notional amount 5% - 4% = 1% x Notional amount CAP is ITM: Reference > Strike If LIBOR t+1 = 3%, then buyer receives (seller pays): Nothing CAP is OTM: Reference < Strike 5 STRIKE rate REFERENCE or INDEX

6. Copyright 2014 by Diane S. Docking Uses of CAPS 1. Protects the Buyer of the Cap from Rising Interest Rates. Limits the Buyer’s interest rate exposure to a ____________ rate. The Cap is the purchase of a call option on interest rates or a put option on prices. The Bank as Buyer of a Cap: Protects the bank from rising interest rates for an up front fee (option premium). Sets a maximum (cap) rate on the bank’s borrowing costs. The Bank as Seller of a Cap: Sets the maximum interest rate that the bank can earn on a customer loan. Protects the customer from rising interest rates. Bank receives an up front fee (option premium) for this. 6

7. Copyright 2014 by Diane S. Docking Uses of CAPS (cont.) 2. Converts VR debt to FR debt, but only if rates increase Bank gets protection from increasing interest rates, yet retains the benefits if rates decrease. If rates decrease, receive 0 under cap and borrowing costs float down. If rates increase, receive rebate of (Index – Cap) and sets a maximum on expense. 3. Converts a FR loan to a VR loan, but only if rates increase Retains protection from decreasing interest rates, but gains advantage of increasing rates. Bank gets minimum revenue of the FR since Cap is OTM if rates fall. But gets benefits of increasing rates because receive rebate of (Index – Cap) which is added to the FR revenue. 7

8. Copyright 2014 by Diane S. Docking Interest Rate Floor Agreements A FLOOR is an agreement where the seller agrees to pay the buyer if the designated reference ___________the strike The Payment or Rebate is given as: Notional Principal Amount x [Strike – Actual Value of Reference] Rebate to buyer = (i floor strike – i index/reference ) x Notional Principal Amount; but only if i index/reference < i floor strike ; else zero. 8

9. Copyright 2014 by Diane S. Docking Interest Rate Floor Agreements (cont.) Eg: FLOOR on LIBOR @ 4% If LIBOR t+1 = 3%, then buyer receives (seller pays): 4% - 3% = 1% x Notional amount FLOOR is ITM: Reference < Strike If LIBOR t+1 = 5%, then buyer receives (seller pays): Nothing FLOOR is OTM: Reference > Strike 9 STRIKE rate REFERENCE or INDEX

10. Copyright 2014 by Diane S. Docking Uses of FLOORS 1. Protects the Buyer of the Floor from Falling Interest Rates. Limits the Buyer’s interest rate exposure to a _____________ rate. The Floor is the purchase of a put option on interest rates or a call option on prices. The Bank as Buyer of a Floor: Protects the bank from falling interest rates for an up front fee (option premium). Sets a minimum (floor) rate on the bank’s lending rates (and thus earnings). The Bank as Seller of a Floor: Sets the minimum interest rate that the bank must pay on bank borrowings. Protects the loaner from falling interest rates. Bank receives an up front fee (option premium) for this concession. 10

11. Copyright 2014 by Diane S. Docking Uses of FLOORS (cont.) 2. Converts a VR loan to a FR loan, but only if rates fall Bank gets protection from decreasing interest rates, yet retains the benefits if rates increase. If rates fall, receive rebate of (Floor – Index) which is added to the VR to guarantee a minimum revenue. If rates increase, receive 0 under floor and revenue floats upward. 3. Converts FR debt to VR debt, but only if rates fall Retains protection from increasing interest rates, but gains advantage of decreasing rates. Bank pays maximum expense of the FR since Floor is OTM if rates rise. But gets benefits of decreasing rates because receive rebate of (Floor – Index) which is added to the FR expense to reduce borrowing costs. 11

12. Cap Example: ABC Co. issued a $40 million 5-year bond at an interest rate = LIBOR + 1%. LIBOR is currently at 3%. At the same time ABC Co. purchased a 5-year cap on LIBOR with a strike = 3% and a premium of 0.5% of the notional amount. Questions?: 1) How much did the cap cost? How is this handled “accounting- wise”? 2) Suppose at the end of year 1 the LIBOR = 4%. Does ABC receive a cap payment ; if so, how much? 3) Suppose at the end of year 1 the LIBOR = 2%. Does ABC receive a cap payment ; if so, how much? 4) What did ABC accomplish by purchasing this Cap? Copyright 2014 by Diane S. Docking 12

13. Solution to Cap Example: 1) How much did the cap cost? How is this handled “accounting-wise”? 2) Suppose at the end of year 1 the LIBOR = 4%. Does ABC receive a cap payment ; if so, how much? 3) Suppose at the end of year 1 the LIBOR = 2%. Does ABC receive a cap payment ; if so, how much? Copyright 2014 by Diane S. Docking 13 ______. LIBOR Reference > CAP strike; therefore receive (Reference – CAP) x Notional amount 4% - 3% = 1% x $40 million = $400,000 ______. LIBOR Reference < CAP strike; therefore receive $0. CAP is OTM. The cap cost = premium x Notional Value =.005 x $40,000,000 = _______________. The $200,000 is paid “upfront”, but is amortized over the life of the cap. In this case $40,000 /yr to expense or 0.1% / yr.

14. Solution to Cap Example (cont): 4) What did ABC accomplish by purchasing this Cap? Sets an upper bound on debt costs. Get lower debt costs if LIBOR decreases; but if LIBOR increases, sets a maximum on debt cost. Maximum debt cost = 4% x $40 million = $1,600,000 per year. Debt Cost bounds [1%; 4%] or [$400,000 ; $1,600,000] Copyright 2014 by Diane S. Docking 14 CAP Strike = 3%If L < 3%If L > 3% Debt cost- (L + 1%) $40 million x (L+1%); for 5 yrs. Cap receipt 0 L – 3% Net debt cost- (L+1%) - 4%

15. Floor Example: ABC Co. loaned $40 million to a customer for 5-years at an interest rate = LIBOR + 3%. LIBOR is currently at 4%. At the same time ABC Co. purchased a 5-year floor on LIBOR with a strike = 4% and a premium of 0.5% of the notional amount. Questions?: 1) How much did the floor cost? How is this handled “accounting- wise”? 2) Suppose at the end of year 1 the LIBOR = 5%. Does ABC receive a floor payment ; if so, how much? 3) Suppose at the end of year 1 the LIBOR = 2%. Does ABC receive a floor payment ; if so, how much? 4) What did ABC accomplish by purchasing this Floor? Copyright 2014 by Diane S. Docking 15

16. Solution to Floor Example: 1) How much did the floor cost? How is this handled “accounting- wise”? 2) Suppose at the end of year 1 the LIBOR = 5%. Does ABC receive a floor payment ; if so, how much? 3) Suppose at the end of year 1 the LIBOR = 2%. Does ABC receive a floor payment ; if so, how much? Copyright 2014 by Diane S. Docking 16 ______. LIBOR Reference > FLOOR strike; therefore receive $0. ______. LIBOR Reference < FLOOR strike; therefore receive (FLOOR - Reference) x Notional amount 4% - 2% = 2% x $40 million = $800,000 The floor cost = premium x Notional Value =.005 x $40,000,000 = $200,000. The $200,000 is paid “upfront”, but is amortized over the life of the cap. In this case $40,000 /yr to expense or 0.1% / yr.

17. Solution to Floor Example (cont): 3) What did ABC accomplish by purchasing this Floor? Sets a lower bound on interest revenues. Get higher revenues if LIBOR increases; but if LIBOR decreases, sets a minimum on interest revenues. Minimum interest revenue = 7% x $40 million = $2,800,000 per year. Revenue bounds [7%; +  ] or [$2,800,000 ; +  ] Copyright 2014 by Diane S. Docking 17 FLOOR Strike = 4%If L < 4%If L > 4% Loan revenueL + 3% $40 million x (L+3%); for 5 yrs. Floor receipt4% - L 0 Net loan revenue 7% L + 3%

18. Interest Rate Collar Simultaneous _________ of an interest rate Cap and ______ of an interest rate Floor, On the same index, For the same maturity, and For the same notional principal amount. Cap rate > Floor rate Copyright 2014 by Diane S. Docking 18 Interest Rate Collar

19. Objective of Buyer of a Collar: To protect against rising interest rates and increasing borrowing costs. The purchase of the Cap protects against increasing interest rates. The sale of the Floor generates premium income which reduces the cost of the Cap. Creates a band within which the buyer’s interest rate costs will fluctuate. Copyright 2014 by Diane S. Docking 19 Interest Rate Collar (cont.)

20. If i index > i cap, then Rebate to buyer = (i index - i cap ) x Notional Principal Amount; (We receive since we are buyer of cap) If i index < i floor, then Rebate to buyer = (i floor - i index ) x Notional Principal Amount; (We pay to buyer since we are seller of floor) Copyright 2014 by Diane S. Docking 20 Interest Rate Collar (cont.)

21. Interest Rate Reverse Collar Simultaneous ________ of an interest rate Floor and ______ of an interest rate Cap, On the same index, For the same maturity, and For the same notional principal amount. Cap rate ≠ Floor rate Copyright 2014 by Diane S. Docking 21 Interest Rate Reverse Collar

22. Objective of Buyer of a Reverse Collar: To protect against falling interest rates and decrease in earnings. The purchase of the Floor protects against decreasing interest rates. The sale of the Cap generates premium income which reduces the cost of the Floor. Creates a band within which the buyer’s interest rate earnings will fluctuate. Copyright 2014 by Diane S. Docking 22 Interest Rate Reverse Collar (cont.)

23.  If i index > i cap, then Rebate to buyer = (i index - i cap ) x Notional Principal Amount; (We pay to buyer since we are seller of cap)  If i index < i floor, then Rebate to buyer = (i floor - i index ) x Notional Principal Amount; (We receive since we are buyer of floor) Copyright 2014 by Diane S. Docking 23 Interest Rate Reverse Collar (cont.)

24. Collar Example: ABC Co. issued a $40 million 5-year bond at an interest rate = LIBOR + 1%. LIBOR is currently at 4%. At the same time ABC Co. purchased a 5-year cap on LIBOR with a strike = 4% and a premium of 0.5% of the notional amount and sold a 5-year floor on LIBOR with a strike rate of 3.0% and a premium of 0.5% of the notional amount. Questions?: 1) What is the net cost of the collar and how is it handled “accounting-wise”? 2) Suppose at the end of year 1 the LIBOR = 5%. Does ABC receive a cap payment or make a floor payment; if so, how much? 3) Suppose at the end of year 1 the LIBOR = 2%. Does ABC receive a cap payment or make a floor payment; if so, how much? 4) Suppose at the end of year 1 the LIBOR = 3.5%. Does ABC receive a cap payment or make a floor payment; if so, how much? 5) What did ABC accomplish by purchasing this Collar? Copyright 2014 by Diane S. Docking 24

25. Solution to Collar Example: 1) What is the net cost of the collar and how is it handled “accounting-wise”? 2) Suppose at the end of year 1 the LIBOR = 5%. Does ABC receive a cap payment or make a floor payment; if so, how much? Copyright 2014 by Diane S. Docking 25 The cap cost = premium x NV =.005 x $40,000,000 = $200,000. The floor revenue = premium x NV =.005 x $40,000,000 = $200,000. Both premiums are paid up front. This is a “______________” collar. In this case $0 /yr to expense or 0.0% / yr. LIBOR Reference > CAP strike 5% > 4% therefore receive (Reference – CAP) x Notional amount 5% - 4% = 1% x $40 million = $400,000 LIBOR Reference > FLOOR strike; therefore pay $0 5% > 3%

26. Solution to Collar Example: 3) Suppose at the end of year 1 the LIBOR = 2%. Does ABC receive a cap payment or make a floor payment; if so, how much? Copyright 2014 by Diane S. Docking 26 LIBOR Reference < CAP strike; therefore receive $0 2% < 4% LIBOR Reference < FLOOR strike; 2% < 3% therefore pay (FLOOR -Reference) x Notional amount 3% - 2% = 1% x $40 million = $400,000

27. Solution to Collar Example: 4) Suppose at the end of year 1 the LIBOR = 3.5%. Does ABC receive a cap payment or make a floor payment; if so, how much? Copyright 2014 by Diane S. Docking 27 LIBOR Reference < CAP strike; therefore receive $0 3.5% < 4% LIBOR Reference > FLOOR strike; therefore pay $0 3.5% > 3%

28. Solution to Collar Example: 5) What did ABC accomplish by purchasing this Collar? Set an upper and lower bound on interest expense. Maximum interest expense = 5% x $40 million = $2,000,000 per year. Minimum interest expense = 4% x $40 million = $1,600,000 per year. Cost bounds [4%; 5%] or [$1,600,000 ; $2,000,000 ] Copyright 2014 by Diane S. Docking 28 CAP Strike = 4%; Floor Strike = 3% If L < 3%If 3% < L < 4%If L > 4% Debt cost- (L + 1%) $40 million x (L+1%); for 5 yrs. Cap receipt 00 L – 4% Floor payment-(3% - L)00 Net debt cost- 4%- (L + 1%) - 5%