An interest rate cap is an option that sets an upper limit to the amount of interest a company will pay on a floating-rate loan for a series of interest rate periods. If the interest rate on the loan breaches the upper limit that has been agreed, the option is exercised and a cash settlement is received from the option writer at the end of the period. Although this hedging instrument helps to protect a company against interest rate rises, there is no lower limit and so it allows a company to take advantage of falling interest rates. An interest rate cap will normally cover a minimum period of two years and a maximum period of five years. The main disadvantage of an interest rate cap is the cost of the premium that is payable to the option writer.
An interest rate floor is an option that sets a lower limit to the amount of interest a company will pay on a floating-rate loan for a series of interest rate periods. The basic principles of the floor are the same as for a cap. If the lower limit is breached, the option will be exercised and a cash settlement is made by the company at the end of the period. In this case, an advantage is the premium cost of the floor.
A collar is an option that sets both an upper limit and a lower limit to the rate of interest payable over a series of periods. It is, in effect, a combination of a cap and a floor. A collar agreement will cost less than a cap as the premium cost of the cap element is offset by the premium receivable from the floor element. It may be possible to arrange for a collar that has no premium, although in such cases the upper and lower limits agreed for future interest rates are likely to be very close together.
Interest rate swap
An interest rate swap offers an alternative approach to managing interest rate risk. This would involve an arrangement between the company and another party (usually another company) whereby the company exchanges its stream of floating rate interest commitments for a stream of fixed rate interest commitments. The two parties to the arrangement may negotiate the swap arrangement directly between each other or through an intermediary. Some banks specialize in swap transactions.
Swap can usually be arranged without difficulty. If a counter-party to the swap arrangement cannot be found, a swap bank is often prepared to undertake this task. Transactions costs for a swap agreement tend to be fairly low. The main costs are legal fees and these may be minimized through the use of standardized contracts. Swap agreements are also flexible and can cover a wide range of sums over a wide range of time periods. The main risk associated with this type of transaction is that the counter-party to the agreement will default on its obligations. However, it may be possible to protect against this risk where an intermediary is used. By paying an additional fee, responsibility for the swap obligations may be taken over by the intermediary.