Interest Rate Caps
Can someone explain the math behind why interest rate caps rarely make financial sense? Is it simply the discounted cash flow of the additional interest cost at some discount rate?
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I would think about interest rate caps more like insurance. If rates suddenly increased to XYZ%, what happens? An interest rate cap puts a limit on what your interest rate can be.
Interest Rate Caps are calculated by summing up the discounted Present Value of the probability of the expected rate (rate in the future at any given point in time) exceeding the strike price.
The way I imagine they are calculated is by running a model to figure out an expected interest rate at every point in time between the date of origination and termination. Then each of those points is assigned a distribution with the further out dates generally assigned greater volatility. Then they calculate the integral of the distribution over the strike price. The discounted present value of the sums becomes the price of the Interest Rate Cap (with a slight markup of course). Depending on structure and payment schedule I can theoretically see there being a double integral if interest rate caps have to be assessed by the minute for example as opposed to by the month.
You're paying a (hefty) premium for an option that would likely expire out the money. It caps your rate exposure for the duration of the cap, but the intrinsic value is zero unless rates hit above the strike. I'm not sure how liquid the derivative is, but I imagine it's not commonly traded in secondary markets.
I work in the capital markets said for a large PE/Development firm. Most of the time when we but caps it's because it's required in the loan agreement. In the past (6 months prior) they were pretty cheap and like you said had no real resale value because the Caps were never in the money. Now that rates have risen a lot of the caps are providing value and won't be expiring for a year or two after disposition we recently had a cap we bought for around 20k and just sold for north of a $1M.Like you said normally not much value on the second hand market but today is a different day.Also a great resource to learn more is Chatham Financial -> insightsHope this helps!
Probably a stupid question but why do lenders require rate caps?
Coincidentally have been looking into this trying to understand interest rate caps more. Isn't is basically an instrument that cap interest rate based on x% Libor (and now SOFR) for variable/adjustable rate loans? Here is an example from an education case study I am working on, it's for a $50mm bridge loan 1 year IO libor 2% rate and spread of 7.5%, a deal from 2009/10. I have a question more about how a sponsor would go about this, is the lender the one that will set the purchase of this cap up or is it on the sponsor to buy this through where and have it before the loan closes? What are some of the other instruments you've seen used besides interest rate caps? It's the first time I've seen this.
My firm is currently going through this exercise. Loan doc calls for a springing rate cap which has been triggered. Process requires us to purchase the cap with a series of conditions including credit rating if the counter party (seller of the instrument). This is not something that the lender has set up for us.
Some other instruments to consider are swaps, corridors and collars.
For the same reason insurance doesn't really "make sense" until it does. You're always going to overpay for it, by definition, because the provider is trying to make a profit.
But the last 4 months have shown us why interest rate caps can make sense. You hear stories all day about people who are getting their caps priced at huge multiples of what they paid last year. This is a weird situation... but it's one where a cap makes sense. Rapidly rising interest rate environment.
They certainly made sense a year ago. Now the cost of the cap themselves represent the worst case scenario of interest rates (which doesn't seem unlikely now).
For example we bought a 3 year $100mm cap with a 1.5% strike a year ago. It was a few hundred grand, now its trading for $7-8mm. Cap prices now kill these type of deals, or force to you leave all that interest rate risk in the deal.
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