MFOOO7 TREASURY MANAGEMENT
Q.4. Explain with the help of an example the concept of ‘Cap’ and ‘Floor’ in relation to an Interest Rate Option.
Answer:
This cap/floor calculator has been developed by the World Bank’s Treasury staff as a flexible tool for calculating indicative pricing for interest rate caps, floors and collars. This manual provides step-by-step details of how to use the cap/floor calculator. If you have any questions regarding this program, please contact the World Bank astaff at the numbers
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A the loan is to be capped provided on the last page of this manual. Initial principal amounthof at
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or collared.
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To value a collar, which is composed of a cap and by a floor, the user needs to run the
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s program twice in order to calculate the cap and floor er premiums. .co The value of the collar is ail
iv g al /20premium @ in a net premium payable to the borrower;nipthe cap must be equal to, or greater than 4 5 a e/0 lva8 M n assumes that the strike rate is compared against the floor premium. The Cap/Floor Calculator m <Ju atha i r LIBOR, although the FSL lending of LIBOR + a fixed spread. If the cap or kk rate consists ha Si s : to net ainterest il collar is triggered, the borrower’s obligation will consist of the strike rate plus the d e m t E FSL or VSL spread. mit b u The interestSpayment date corresponding to the first interest payment period is capped 9> premium. obtained by subtracting the floor premium from IBRD collars cannot result m Unthe0cap
or collared. This date can be no earlier than six months and two business days following the Trade Date, and should fall on an interest payment date on the underlying loan. For IBRD loans, the interest payment date must fall on either the 1st or the 15th of the month. The interest payment date corresponding to the last interest payment period is capped or collared. In most cases, this date would be at least six months after the First Payment Date, should fall on an interest payment date on the underlying loan, and should not exceed the final maturity date of the underlying loan. (See example under “First Payment Date”). The Last Payment Date cannot precede the First Payment Date. To create a caplet (an interest rate cap on a single interest period), the Last Payment Date should be identical to the First Payment Date. The annual interest rate volatility is the Page 6 of 10