Life Cap

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 . 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 .

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:

• 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 .

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 :

• (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.

Examples of Life Cap

• For example, a loan might have a life cap of 5%, which means the interest rate can increase no more than 5% during the life of the loan.
• Another example could be a loan with a life cap of 3%. In this case, no matter how the market interest rate changes, the interest rate on the loan can never increase more than 3%.
• A third example is a loan with a life cap of 10%. In this case, the interest rate on the loan can never go above 10%, regardless of what the current market rate is.
• A fourth example could be a loan with a life cap of 0%. This means that the interest rate can never increase, no matter what the market rate is.

Advantages of Life Cap

Life caps are beneficial for borrowers in many ways. They provide a sense of security and protection from excessive rate increases over the term of a loan. The following are some of the advantages of using a life cap:

• A life cap ensures that the interest rate on a loan will not exceed a certain amount, giving borrowers the assurance that they will not be hit with unexpectedly high payments.
• By limiting the amount of interest rate increases, a life cap can provide borrowers with financial stability since they can plan and budget with greater certainty.
• A life cap may also help to protect borrowers from defaulting on their loans if interest rates were to rise significantly over the course of the loan.
• Finally, a life cap can provide borrowers with peace of mind, knowing that their interest rate will not increase beyond a certain level.

Limitations of Life Cap

One of the limitations of a life cap is that it does not take into account variable rate loans. Variable rate loans can change from month to month, and the life cap does not account for this. Other limitations include:

• The life cap does not consider when the interest rate will increase. It only considers the maximum amount that it can increase over the life of the loan.
• The life cap does not always accurately reflect changes in the market. If interest rates decline after the loan is taken out, the life cap may limit the borrower's ability to benefit from the decline.
• The life cap does not consider the borrower's ability to pay the additional interest. If the borrower can not afford the additional amount, the loan may end up in default.
• The life cap may limit the ability to obtain a lower interest rate if the loan is refinanced. If the current interest rate is below the life cap, the borrower may not be able to take advantage of a lower rate.

Other approaches related to Life Cap

The life cap is one of the approaches used to limit the amount of interest rate increase on a loan. There are other approaches that can be used as well, such as:

• Loan caps: This places a limit on the total interest rate that can be charged on a loan.
• Adjustable-rate caps: This is a limit placed on the amount of change in interest rate that can occur over a set period of time.
• Interest rate floors: This sets a minimum interest rate that must be adhered to.

These approaches are designed to provide borrowers with an additional layer of protection from large, sudden increases in the interest rate on their loan. By limiting the amount of increase, borrowers can make more informed decisions about their finances and avoid being taken advantage of.

In summary, the life cap is just one of several approaches used to limit the amount of interest rate increase on a loan. Other approaches include loan caps, adjustable-rate caps, and interest rate floors. These approaches help to ensure that borrowers are not subjected to large, sudden increases in the interest rate on their loan.

Footnotes

Life Cap — recommended articles

Sinkable bond — Yield maintenance — Short rate cancellation — Adjustable Life Insurance — Short lease — Grant date — Effective rent — Variation Margin — Full Ratchet

References

• Davidson J., Wilson T. (2008), Interest rate caps : protection or paternalism, „Centre for Credit and Consumer Law”, Griffith University, pp. 27 - 30
• Deventer Van D.R., Imai K. Mesler M. (2013), „Advanced Financial Risk Management, Second Edition: Tools and Techniques for Integrated Credit Risk and Interest Rate Risk Management”, Singapore, pp. 548 - 550
• Howell N. (2013), Interest rate caps and price regulation in consumer Credit, „Consumer Law and Policy in Australia and New Zealand”, Publisher: The Federation Press, Editors: Malbon J., Nottage L., Chapter: 11
• King U., Parrish L. (2007), Springing the debt trap: Rate caps are only proven payday lending reform, „Center for Responsible Lending”, pp. 12 - 14
• Manning I., de Jonge A. (2006), Regulating the cost of credit, „Consumer Affairs Victoria”, Research paper no. 6, pp. 3 - 5

Author: Hubert Olech