If you are considering taking out a variable-rate loan, you may be wondering how to protect yourself from the risk of rising interest rates. One possible solution is to buy an interest rate cap, which is a type of interest rate derivative (IRD) contract that limits the maximum interest rate you have to pay on your loan.
For example, suppose you have a Rs.50 million loan with a variable interest rate of MIBOR plus 2%. You want to hedge your interest rate risk (i.e MIBOR) for three years and limit your maximum interest rate to 6%. You can buy a 3-year Cap having Rs. 50 million notional with strike rate of 6% from a bank. This means that if MIBOR rises above 6% at any time during the next three years, the bank will pay you the difference between MIBOR and 6%, multiplied by the notional and adjusted for the payment frequency. Please note that you will not receive any payments from bank if interest rates stay below your strike rate throughout the term of the cap.
For buying a cap, one need to pay one-time premium, often expressed as x% of notional. The cost of an interest rate cap (i.e. premium to be paid by Cap buyer to the bank) depends on several factors, such as:
– Notional: Generally, a larger notional means a higher cost.
– Cap Term: Generally, a longer term means a higher cost.
– Strike rate: Generally, a lower strike rate means a higher cost.
– Benchmark & its volatility: This is the market-implied expectation for SOFR/SONIA/MIBOR over the term of the cap. A higher key rate means a higher cost. A higher volatility means a higher cost.
—————————————-
Are there any alternatives to Cap?
IRS – One can hedge interest rate risk by entering into an Interest rate swap (IRS), which is another type of IRD wherein you can exchange variable-rate payment for a fixed-rate payment (i.e. receive floating rate and pay fixed rate on notional). Unlike an interest rate cap, there is no upfront cost associated with an IRS. However, with an IRS you cannot take advantage of a low-interest-rate environment because you pay a fixed interest rate throughout the term. Additionally, pre-termination of a IRS can come with significant termination costs.
IRF – One can hedge against the risk of rising interest rates by shorting exchange traded Interest rate futures (aka Bond Futures). These contracts are cash-settled. If interest rates rise, the gain on the contract will offset the higher interest rate that you have to pay on your loan. Conversely, if interest rates fall, you will experience a loss on the contract which will offset the lower interest rate that you are now paying. However, hedging using IRF may not be effective as Cap.