Cap Finance: A Practical Example

Cap finance refers to a derivative contract that provides protection against rising interest rates. It essentially sets a maximum interest rate (the “cap rate”) that the borrower will pay on a floating-rate loan or debt instrument. In exchange for this protection, the borrower pays the seller (often a bank or financial institution) a premium.

Scenario: ABC Manufacturing

Let’s consider ABC Manufacturing, a company with a $10 million loan tied to the 3-month LIBOR rate. ABC is concerned that rising interest rates will significantly increase their borrowing costs and negatively impact their profitability. They decide to purchase a cap finance agreement to hedge against this risk.

Details of the Cap

• Notional Principal: $10 million (matches the loan amount)
• Term: 3 years (matches the remaining term of the loan)
• Cap Rate: 4% (the maximum interest rate ABC will pay)
• Index: 3-month LIBOR (the benchmark rate used in the loan agreement)
• Premium: 1% of the notional principal, or $100,000 (paid upfront to the seller)

How it Works

Every three months, the 3-month LIBOR rate is compared to the cap rate of 4%. If the 3-month LIBOR rate is below 4%, ABC receives nothing from the cap seller. ABC pays the prevailing LIBOR rate on their loan, just as they would without the cap.

However, if the 3-month LIBOR rate is above 4%, the cap seller pays ABC the difference between the actual LIBOR rate and the cap rate, multiplied by the notional principal. This payment is designed to offset the increased interest expense ABC incurs on their loan.

Example Payment

Let’s say that in one quarter, the 3-month LIBOR rate is 5%. This is 1% above the cap rate of 4%. The cap seller will pay ABC:

(5% – 4%) * $10,000,000 * (90/360) = $25,000

Where 90/360 represents the number of days in the quarter (approximately) divided by the number of days in a year.

ABC receives $25,000 from the cap seller. While they are paying 5% on their $10 million loan, effectively their net interest expense is capped at 4%, plus the initial premium amortized over the life of the cap.

Benefits and Considerations

Benefits:

• Protection against rising rates: Provides certainty and predictability in borrowing costs.
• Budgeting: Allows for more accurate budgeting and financial planning.
• Risk management: Mitigates the risk of interest rate volatility.

Considerations:

• Premium cost: Requires an upfront payment, which reduces available cash flow.
• Opportunity cost: If interest rates fall below the cap rate, ABC still paid for protection they didn’t need.
• Complexity: Cap agreements can be complex financial instruments, requiring expertise to understand and manage.

In conclusion, cap finance offers a valuable tool for managing interest rate risk. By purchasing a cap, companies like ABC Manufacturing can limit their exposure to rising rates and ensure more stable borrowing costs. However, it’s crucial to carefully consider the costs and benefits before entering into a cap agreement.