Dow Schofield Watts llp

Interest rate caps  

A cap is a contract between the bank and the customer which the customer buys and which gives the customer money if interest rates are higher than an agreed level (the “Strike”).  The customer does not have to pay anything further even if interest rates move up or down.

The important aspects of a cap are:

This is paid by the customer to the bank at the start of the cap.

This is the interest rate above which the bank will pay the customer.

This is the rate of interest at which banks offer deposits to other banks.  LIBOR is the market price of money at any time.  (Base rate is not the same, although base rate and LIBOR are usually at similar levels).  LIBOR depends on the length of time that the deposit is to be placed and is applied for the whole of the period.  for example a three month deposit might be placed by a bank at 6.25% and this rate (“3-month LIBOR”) will apply to the deposit for the three months regardless of interest rate movements.

This is the length of the cap contract, usually an exact number of years.

This is the notional amount of money which is multiplied by the difference between LIBOR and the strike rate to calculate the amount the bank will pay the customer.

General three or six months, these determine which LIBOR (3-month LIBOR  or 6-month LIBOR) will be used and how often payments will be made to the customer.

As an example, suppose a customer has a borrowing of £150,000 which he wishes to protect against rises in interest rates.  Interest on the borrowing is charged at base rate plus a margin.

The customer could buy a £150,000 (or less, if the customer wanted to incur less cost in return for retaining some of the risk) cap with a maturity of three years.  The cap is based on 6-month LIBOR, with interest periods beginning on 10 March and 10 September.  The strike rate chosen by the customer is 7%.  The start date is 10 March 1993 and the transaction date is 10 March 1996.  The price is £4,020.

The customer pays the bank the £4,020 for the cap at the time the contract is agreed.  On 10 March and 10 September each year a calculation is made to see whether (and how much) payment should be made.  The payments are calculated according to a formula which uses the exact number of days involved and any payment is made at the end of the interest period.

The following table shows the payments the bank would make (simplifying the number of days in each six month period for the purposes of the example):

The LIBOR rates shown are hypothetical.  If they are higher the bank will pay more and vice versa.

This means that for a payment of £4,020 (2.68% of £150,000 or approximately 0.9% per annum), the customer is substantially protected against interest rates rising above 7% plus the interest margin.  There is no limit to the amount the bank will pay and the payment of £4,020 is the customer’s only liability.