The interest rate swap is not the only hedging and investing tool in the derivatives arsenal. Investors and issuers can also purchase related derivatives known as interest rate caps, floors, and collars.
These other derivatives provide conditional protection or profit based on moves in interest rates. But because of the conditional nature of the derivatives, the products contain a type of option, which can complicate pricing.
An interest rate cap is simply a contract that pays the holder interest when a market index exceeds a set level, called the strike price. The interest is calculated from a base amount, which is not exchanged. Typically, a cap purchaser pays the provider an upfront fee.
For example, one month ago, a dealer offered interest rate caps on the Public Securities Association's municipal swap index. At the time, the index stood at 2.51%.
The dealer offered caps at a strike price of 4%. The cap would pay the holder only if the PSA index rose above that level. For a cap maturing or expiring, in two years, the dealer charged an upfront fee of six basis points. The fee, and any interest paid, would be based on a set amount not exchanged.
If, within the two-year maturity of the cap, the PSA index rose to 4.5%, the investor's bet would pay off. The cap provider would pay the cap holder the difference between the strike price on the cap of 4% and the market index at 4.5%. So, with the PSA index at 4.5%, the provider would have to Pay 0.5% to the cap holder.
An interest rate floor is the reverse of a cap. The floor provider will pay the holder if a market index drops below a preset level before the floor expires. Again, the buyer of a floor must pay an up-front fee.
For example, if an investor purchased a floor with a strike price of 2% and the. PSA index dropped to 1.5%, the floor provider would pay the holder 0.5%.
A collar is the combination of a floor and and a cap. The collar provider pays the holder if a market index either drops below a set rate or rises above a higher set rate.
For example, an investor may the PSA index drops below 2% or rises above 6%.
Caps, floors, and collars pay off conditionally, like a stock option, so valuing these products requires an option pricing model, like Black-Scholes. The models value options based on a number of factors, not just the movement of interest rates.
The basic terms of the option obviously affect its value. The longer the maturity, for example, the more valuable the option. Similarly, the closer the strike price is to the benchmark index, the more valuable the option.
As interest rates move toward the strike price -- rising in the case of a cap or falling in the case of a floor -- the option becomes more valuable.
Changes in the shape of the yield curve can also affect the value of the option. Generally, as the yield curve steepens, caps become more valuable, and as the yield curve flattens, floors become more valuable.
The final variable, volatility, may be the most difficult to predict. Volatility is a measure of the amount of change expected in the future. In the caps and floors business, volatility is often expressed as the standard deviation of recent interest rate changes.
A measure of volatility does not indicate whether rates will rise or fall, but simply how much rates will move in either direction.
Options are priced based on expected future volatility. This expected volatility, also called implied volatility, may be quite different from recent historical volatility in the market.
As volatility increases, both caps and floors become more valuable. Volatility complicates the option provider's task of hedging the option.
In general, large Wall Street firms and commercial banks sell caps, floors, and collars. Because these providers are not tax-exempt entities, any payoff on a derivative from them would be taxable.
To meet the demand for tax-free products, some underwriters have embedded caps and floors in tax-exempt bonds. In these transactions, the cap is sold to the issuer of the tax-exempt bond. The issuer agrees to pass through to bondholders any payments that come in from the cap. Because the payments pass through the tax-exempt issuer, the bondholder receives tax-exempt interest.