Pricing Caps, Floors, and Collars in BondEdge

Ying Shen, Ph.D.

Caps and Floors are among the most liquid over-the-counter interest rate derivative products on the market. They are widely used by banks, funds and large companies for hedging interest risk purposes. An interest rate cap is an agreement that places a predetermined upper bound on borrower's floating interest rate to a fixed level, the cap rate, for each given period of time. Therefore, a cap guarantees that borrower's floating rate at any time will not exceed the cap rate. In practice, when a cap and its underlying loan are both provided by the same financial institution, the option cost of the cap is often incorporated into the interest rate charged. When they are provided by different financial institutions, an upper-front payment for the cap is likely to be required. An interest rate floor works similarly, but inversely, in that the borrower's floating interest rate will not go below the agreed fixed rate, the floor rate, for each given period of time. An interest rate collar is an agreement that places both the upper limit and the lower limit on the interest rate that will be charged. Equivalently, one can regard a collar as a long position on a cap and a short position on a floor with the same characteristics of reset dates and settlement dates.