Capped floaters

Floating-rate notes can include additional features. One example is the inclusion of cap, floor and collar clauses. A floater with cap feature means that the reference rate cannot overcome the threshold rate defined in the indenture. Usually the threshold is expressed in terms of coupon, that is after a coupon threshold (e.g. 6%, reference rate plus quoted margin) the investor receives at maximum the cap level. In this case, the floater is not completely covered by rising interest rates, in which after the threshold the floater trades as a conventional bond. In contrast, a floater with a floor feature represents the minimum coupon level that an investor can receive, hedging to the downside risk of interest rates. If the bond includes both cap and floor, this feature is known as collar or collared floating-rate note. The bond can include also a drop-lock feature that after a threshold it ceases to float. 

There are several features about floaters that deserve mention. First, a floater may have a restriction on the maximum (minimum) coupon rate that be paid at any reset date called a cap (floor). Second, while a floater s coupon rate normally moves in the same direction as the reference rate moves, there are floaters whose coupon rate moves in the opposite direction from the reference rate. These securities are called inverse floaters. As an example, consider an inverse floater issued by the Republic of Austria. This issue matures in April 2005 and delivers semiannual coupon payments according to the following formula ... 

We will illustrate this process using a hypothetical 4-year floater that deliver cash flows quarterly with a coupon formula equal to 3-month LIBOR plus 15 basis points and does not possess a cap or a floor. The coupon reset and payment dates are assumed to be the same. For ease of exposition, we will invoke some simplifying assumptions. First, the issue will be priced on a coupon reset date. Second, although floaters typically use an ACT/360 day-count convention, for simplicity we will assume that each quarter has 91 days. Third, we will assume initially that the LIBOR yield curve is flat such that all implied 3-month LIBOR forward rates are the same. (We will relax this assumption shortly.) Note the same principles apply with equal force when these assumptions are relaxed. 

A range floater is a combination of a capped and floored note. The investor receives a floating rate, subject to both a maximum and a minimum rate. Effectively, the investor has sold a cap and bought a floor. The net premium paid or received will either detract or enhance the return from the note in-between the two strike rates. 

Figure 13.1 specifies that the inverse floater has a minimum coupon on 0 percent. The floor is passed on from the note issuer to the swap bank via the swap. This, in eflfect, caps the note holders LIBOR exposure at 7.875 percent (15.75 divided by two). The bank s swap leaves it exposed to a rise in LIBOR above this level. To be fully hedged, the bank must buy an interest rate cap on LIBOR with a strike rate of 7.875 percent. The cap costs 15 basis points, which explains the spread over the coupon rate in the swap structure. 

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