Cap & Floor

Product Training

By Meghna Chhabria
Agenda List

What is Cap & Floor

Example of Cap & Floor

Payoff

Components

Constant Maturity

2
What Is Cap?

In a Cap, the seller agrees to compensate the buyer for the amount by
which an underlying rate exceeds a specified rate on a series of dates
during the life of the contract.

Caps can be viewed as insurance, ensuring that the maximum

borrowing rate never exceeds the specified cap level. In exchange for
this peace of mind, the buyer pays the seller a premium.

3
How Caps Work
A cap has multiple potential payoffs determined by a settlement
frequency and a maturity

At each settlement date, if the underlying index is below the strike
rate, no payments are exchanged (except the premium)

If the underlying index exceeds the strike rate, the seller of the cap
must pay the difference of the index rate and the strike rate.

Formula
(Index Rate - Strike Rate)  (Daycount Fraction)
 Notional Amount

4
Payoff – Buy CAP
• Buyer pay the premium to purchase the Cap.

• Payoff is similar to a buy call.(ATM, OTM, & ITM).

• Underlying Reference Index - GBPL3M for duration of 2 yrs.

Month Notional Strike Index Rate Difference Payoff

Feb ‘15 500000000 0.57 0 0 -279500

May ‘15 500000000 0.57 0.56463 0 0

Aug ‘15 500000000 0.57 0.57094 0.00094 1158.9041

Nov ‘15 500000000 0.57 0.58563 0.01563 19483.973

Feb ‘16 500000000 0.57 0.57188 0.00188 2369.3151

5
Payoff – Buy CAP

Payoff

20000 19483.9726

15000

10000
Payoff

5000 2369.315068

1158.90411
0

0
Feb ‘15 May ‘15 Aug ‘15 Nov ‘15 Feb ‘16
-279500

-5000

6
Payoff – Sell CAP

• Underlying Reference Index - USDL3M for duration of 2 years

Month Notional Strike Index Rate Difference Payoff

Feb ‘15 500000000 0.28 0 0 275000

May ‘15 500000000 0.28 0.2609 0 0

Aug ‘15 500000000 0.28 0.28585 0.00585 -7212.329

Nov ‘15 500000000 0.28 0.3316 0.0516 -64323.288

Feb ‘16 500000000 0.28 0.3932 0.1132 -142663.014

7
Payoff – Sell CAP

Payoff

300000

250000

200000

150000 275000

100000 Payoff

50000

0
Feb ‘15 May ‘15 Aug ‘15 Nov ‘15 Feb ‘16
-50000
-7212.329
-64323.3 -142663.01
-100000

-150000

8
What Is Floor?

In an floor, the seller agrees to compensate the buyer for a rate
falling below the specified rate during the contract period.

Floors are used in times of decreasing short term interest rates by

money managers trying to obtain higher cash returns on fixed rate
investments.

9
How Floor Works

At each settlement date, if the underlying index is above the strike
rate, no payments are exchange (except, the premium is paid).

If at a settlement date, the underlying index is below the strike rate,
the seller of the floor must pay the difference of the strike rate and
the index rate.

Formula
(Strike Rate - Index Rate)  (Daycount Fraction)
 Notional Amount

10
Payoff – Buy FLOOR

• Underlying Reference Index – EUR1M for a duration of 2 years with

payment frequency monthly.
Month Notional Strike Index Rate Difference Payoff

Feb ‘15 10000000 -0.01 0 0 -6500

Mar ‘15 10000000 -0.01 0.001 0 0
Apr ‘15 10000000 -0.01 -0.012 0.002 16.99
May ‘15 10000000 -0.01 -0.034 0.024 216.99
Jun ‘15 10000000 -0.01 -0.054 0.044 337.53
Jul ‘15 10000000 -0.01 -0.066 0.056 460.27
Aug ‘15 10000000 -0.01 -0.073 0.063 552.33
Sep ‘15 10000000 -0.01 -0.094 0.084 690.41
Oct ‘15 10000000 -0.01 -0.107 0.097 797.26
Nov ‘15 10000000 -0.01 -0.119 0.109 925.75
Dec ‘15 10000000 -0.01 -0.155 0.145 1191.78
Jan ‘16 10000000 -0.01 -0.201 0.191 1726.85
Feb ‘16 10000000 -0.01 -0.231 0.221 1755.89
Mar ‘16 10000000 -0.01 -0.261 0.251 1994.25

11
 Payoff – Buy FLOOR

Payoff
2000
1500 1191.78
797.26 925.75 1755.89
690.41
1000 460.27 552.33
216.99 337.53 1726.85 1994.25
500 16.99
0 0
Feb ‘15 Mar ‘15 Apr ‘15 May ‘15 Jun ‘15 Jul ‘15 Aug ‘15 Sep ‘15 Oct ‘15 Nov ‘15 Dec ‘15 Jan ‘16 Feb ‘16 Mar ‘16
-500
-1000
-1500
-2000 Payoff
-2500
-3000
-6500
-3500
-4000
-4500
-5000
-5500
-6000
-6500

12
Payoff – Sell FLOOR
• Underlying Reference Index – JPYL1M for a duration of
2 years with payment frequency monthly.
Month Notional Strike Index Rate Difference Payoff
Feb ‘15 10000000 0.068 0 0 3000
Mar ‘15 10000000 0.068 0.07071 0 0
Apr ‘15 10000000 0.068 0.07071 0 0
May ‘15 10000000 0.068 0.07071 0 0
Jun ‘15 10000000 0.068 0.06643 0.00157 -12
Jul ‘15 10000000 0.068 0.065 0.003 -24
Aug ‘15 10000000 0.068 0.06143 0.00657 -57
Sep ‘15 10000000 0.068 0.053 0.015 -123
Oct ‘15 10000000 0.068 0.02929 0.03871 -318
Nov ‘15 10000000 0.068 0.04 0.028 -237
Dec ‘15 10000000 0.068 0.04357 0.02443 -200
Jan ‘16 10000000 0.068 0.05286 0.01514 -136
Feb ‘16 10000000 0.068 0.04857 0.01943 -154
Mar ‘16 10000000 0.068 -0.04329 0.11129 -884

13
Payoff – Sell FLOOR

Payoff
3000

2500

2000

1500 3000

Payoff
1000

500

0 0 0
0
Feb Mar Apr ‘15 May Jun ‘15 Jul ‘15 Aug Sep Oct ‘15 Nov Dec Jan ‘16 Feb Mar
‘15 ‘15 ‘15 -12 ‘15 ‘15
-123 ‘15 ‘15 ‘16 ‘16
-500 -24 -57 -318 -237 -200 -136 -154
-884

-1000

14
Components Of Cap/Floor

Trade Date
Effective Date
 Maturity
 Strike Rate
Floating Rate/underlying index
Notional
Upfront Premium
Settlement frequency

15
Constant Maturity Swap

• The underlying in a constant maturity swap is a combination of two

swap rates. Example: USD 10 yr – USD 2yr swap rate.

•Also, there is no periodic payment or calculation done during the life

of the trade. Only at maturity the difference between the two rate is
calculated and if it exceeds the strike , then the seller of a cap/ floor
has to pay to the buyer.

•Example of Constant Maturity Swap.(EQS: )

16
Any questions??

17