EURIBOR setting

In any 6-month period when the EURIBOR setting is below 3%, the interest rate cap struck at 3% is out-of-the-money and does not affect the borrower, who can benefit from the lower rates, especially at the outset. However, whenever EURIBOR fixes above 3%, the interest rate cap pays the difference between the 3% strike rate and the rate prevailing. For example, if EURIBOR fixed at 4%, the company would receive 5,000 from the cap counterparty (assuming a 180-day period), and this sum would bring the effective EURIBOR down from 4% to 3% for that period. 

The diagram highlights for each caplet the difference between the option period and the protection period. For example, the last caplet has a 4.5 year option period during which interest rates can vary and expose the company to risk. When the caplet expires, the caplet provides compensation over the 6-month protection period if the EURIBOR setting at the outset of that period exceeds the strike rate. 

You can see why a cap is actually a combination of single-period options by thinking about what happens every six months. In our example, the expiry dates of the nine caplets are set to coincide with the company s EURIBOR setting dates. Six months after the loan commences, the rate for the second interest period will be set by reference to the EURIBOR fixing that day. On the same date, the first caplet expires. If EURIBOR is above the strike rate of 3%, the company will exercise the caplet and receive compensation if EURIBOR is lower, the company will simply let the caplet expire worthless. The same process will apply six months later, and so on. 

An interest cap therefore features multiple exercise dates. The holder can decide on each EURIBOR setting date whether or not to exercise the corresponding caplet. Contrast this with the bond and STIR options seen earlier, which have a single exercise date. 

The result for the company is that EURIBOR will effectively be collared in the range 2.50% to 3.50%. If EURIBOR ever rose above 3.50%, the company s costs would be capped at that level. The downside is that whenever the EURIBOR setting was below 2.50%, the company would not pay less. As neither the cap nor the collar include the first interest period, the company in this example is assured of six months borrowing based on a EURIBOR of 2%. Thereafter, even if EURIBOR were to stay low, the company s borrowing would be based on a EURIBOR of at least 2.50%. This may nonetheless still prove less expensive than paying the fixed rate of 3% throughout, which is what the swap would involve. 

The structure is achieved by XYZ effectively buying 5-year caps struck at 4.50% on five times the notional principal of the note issued. Eor example, if XYZ issued notes with a face value of 10 million, it would effectively buy interest rate caps from investors with a notional principal of 50 million. The up-front premium of 19 bp in this example, therefore, becomes geared up to 95 bp, equivalent to 20 bp p.a. This enables the investor to receive their enhanced coupon, but the geared payment from the caps sold means that investors return diminishes rapidly in any period where EURIBOR sets above 4.50%. 

For example, suppose the ratchet cap initially had a strike rate of 3%, and a spread of 50 bp. So long as EURIBOR stayed below 3%, the caplets would expire out-of-the-money, and the strike rate would remain at 3%. The first time that EURIBOR sets above 3%, however, the expiring caplet would result in a payment to the owner of the cap, but the strike rates for all the remaining caplets would be reset to 3.5%. The cap would therefore not pay out again until rates rose to this higher level, whereupon the strike rate would be ratcheted up to 4%, and so on. 

If EURIBOR sets above the strike rate of 3.5%, the cap purchased by the company limits the effective borrowing cost to 4.5%, 1% above the cap strike, while the floor for that period expires out-of-the-money. The company s maximum borrowing rate is therefore capped, in the same way as with a zero-cost collar. 

An alternative solution is for the company to buy a 5-year interest rate cap on 6-month EURIBOR. Exhibit 17.17 illustrates the effect of such a cap if the strike price were set at 3%. 

Suppose an investor has purchased a 5-year note paying 6-month EURIBOR plus 50 bp, with 6-month EURIBOR initially set at 2%. Interest rates are currently very low, so the investor is thinking about using a 5-year swap to boost the return. With 5-year swaps quoted at 3%, against EURIBOR flat, the investor could switch from 6-month EURIBOR plus 50 bp to an effective yield of 3.5%, enjoying an immediate 100 bp improvement in yield. This structure is pictured in Exhibit 17.30. 

The cash flows for this transaction are set forth in Exhibit 19.1. The second column of the exhibit shows the cash flows from purchasing the 5-year floating-rate bond. There is a 50 million cash outlay and then 10 cash inflows. The amount of the cash inflows is uncertain because they depend on future levels of 6-month EURIBOR. The next column shows the cash flows from borrowing 50 million on a fixed-rate basis. The last column shows the net cash flows from the entire transaction. As the last column indicates, there is no initial cash flow (no cash inflow or cash outlay). In all 10 6-month periods, the net position results in a cash... 

FRNs can have additional features, such as flbors, which specify minimum levels below which the coupon cannot fall caps, which specify maximum rates and calls, which specify possible redemption dates before maturity. Perpetual FRNs also exist. As in other markets, borrowers frequently issue floating notes with specific, even esoteric, terms to meet particular requirements or customer demands. For example. Citibank issued a series of U.S. dollar—denominated FRNs indexed to the Euribor rate and another set of notes whose day count was linked to a specified LIBOR range. 

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