Life Cap

Life Cap
See also

Life cap is the maximum amount by which a borrower's interest rate can increase during the term of a loan. The time limit assumes an interest rate change or an absolute interest rate.

The life cap option is used to hedge against interest rate increases and is automatically exercised if the life cap option's exercise rate is lower than the reference rate for a specific interest period.

The Buyer rights

Before the interest accrual date, the option buyer may notify the option issuer of the lack of intention to exercise the option (the option buyer deliberately resigns from his right to exercise the option). In such a case, the option will not be exercised, even if the comparison of the option exercise rate with the reference rate shows that the option would be subject to exercise.

The Buyer of the life cap interest rate option has the right (but not the obligation) to convert the amount of interest accrued on the transaction amount at the reference rate into the amount of interest accrued on the transaction amount at the exercise rate, assuming that the transaction is settled only by the payment of the settlement amount [1]. For this right, the option purchaser pays the option issuer a specified price in the form of an option premium. When entering into interest rate option transactions, the parties may agree on one or more interest periods for a given transaction and change the transaction amount on agreed days [2].

Functions of life cap

Life cap provides an effective way to limit interest rate increases. Unlike standard options, there is no single maturity. For the entire life of the instrument, there are from a few to several dozen settlement periods. At the end of each of them (e.g. every month, quarter or half a year), the option holder receives a specific amount if a given market interest rate called the reference rate, exceeds the predetermined strike price (the so-called upper cap rate).

The other party to the transaction is[3]:

  • the option issuer, who counts that the market rates will not rise to the assumed ceiling.

If it does, however, it will have to settle its obligations towards the option holder. In return, he receives a bonus at the very beginning. This type of instrument also differs from ordinary options in its relatively long duration. Options of this type are usually issued for a period of between one and seven years.

On the other hand, it is worth noting that, from a mathematical point of view, an interest rate cap option is nothing more than a portfolio of ordinary call options, but with different expiry dates [4].

Calculation of life cap

The amount of payment which the option Issuer is obliged to pay, if any, is calculated according to the formula below [5]:

  • (annual reference rate - ceiling)×(number of days in the settlement period/number of days in the year)×(nominal value of the option).

The detailed method of calculating the amount of the payment shall depend on the convention applicable in the country concerned for the number of days of the year. For example, in the case of the US dollar Libor rate, it is assumed that the number of days in a year is 360.

Footnotes

  1. I. Manning, A. de Jonge 2006, pp. 3 - 5
  2. J. Davidson, T. Wilson 2008, pp. 27 - 30
  3. U. King, L. Parrish 2007, pp. 12 - 14
  4. Van D.R. Deventer, et al. 2013, pp. 548 - 550
  5. J. Davidson, T. Wilson 2008, pp. 27 - 30

References

Author: Hubert Olech