A vanilla cap, more commonly known simply as a cap, protects its buyer from a rise in the interest rate above the level (i.e., the strike) specified in the contract.
The cap itself consists of a series of caplets. Each caplet successively ensures the buyer protection against a rise in the interest rate above the strike for a single payment period of the floating rate liability.
That is, if on the caplet’s fixing date (usually set at the start of the payment period) the interest rate is above the strike, the cap seller must pay the buyer a payoff as follows (usually at the end of the payment period):
(Interest rate index - Strike) * Notional * Relevant daycount fraction
Typically the reference rate is set in advance, i.e., it is fixed at the start of each payment period and paid at the end of the same period. However, it can also be fixed in arrears.
In return for this protection, the buyer of the cap pays a premium to the seller. Expressed as a percentage of the notional, the premium is usually paid upfront. However, it can also be paid in installments over the life of the cap.
For example, you buy a cap based on 3-month LIBOR with a strike of 4%, on a notional of $1,000,000. On each caplet date, you will receive money if the 3-month LIBOR is over 4%. So if on a caplet date the 3-month LIBOR is 5%, you will receive the following:
(5% - 4%) * $1mio * (3months/1year) = 1% * 1/4 * $1mio = $2,500
Advantages of a Cap
Because it acts as an upward hedge, buying a cap lets you set a maximum limit on a floating rate exposure over a specified period, while giving you the flexibility to benefit from any reduction in rates.
Pricing a Cap in SDX Interest Rates
When pricing a cap in SDX Interest Rates there are a number of things to be aware of:
By default the instrument’s start date is defined by the frequency. For example, if the cap has a 3m frequency, by default the start date of the first coupon will be the spot date (i.e., the trade date) + 3m, due to the fact that the current index fixing is known at the outset. You can of course change this to always be simply the spot date. You do this in the Settings window. For more information see Customizing the Start Date of a Cap/Floor.
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If you have configured the Cap/Floor 1st Fixing setting to “Today + Frequency”, and in the pricing page after defining the tenor you then edit the frequency used, the system automatically updates the start date accordingly. That is, the start date is automatically edited to take account of the new frequency setting. However, it is also important to note that if you manually enter the start date, subsequently changing the frequency setting will not affect the start date. |
The premium, which is expressed as a percentage of the notional, is usually paid upfront. However, it can also be paid in installments over the life of the cap.
The upfront payment to be made for a cap is shown in the Market Price result. The Amortize premium result shows the annual periodic payment that would be paid if the cap was bought in installments.
By default the Amortize premium result is not displayed. You can choose to display it in the Settings window. For more information see Displaying the Cap/Floor Premium as an Amortized Value .
By default, the system sets each payment on the relevant caplet’s end date. You can change these dates manually. In addition, you can instruct the system to set the payments on the caplets’ start dates instead.
For more information on this functionality see Configuring Payments to Coupon and Caplet Start Dates.
You can also enter your own market volatility and then re-calculate the Greeks and various values. See Market Vol.