Question

12. A bank enters into an interest rate cap with a ceiling of 12%. The notional principal is $50 million, and LIBOR is the index used to represent current interest rates. What is the first year's payment if LIBOR is 9%? A. Bank pays $1.5 million. B. Bank receives $1.5 million. C. $0. D. Bank receives $3million.

Answer 1

Solution :

An Interest rate Cap is an agreement between the buyer and seller of the cap, to receive the difference in Interest cost (on Notional Principal), when a specified index of market interest rates rises above the specified cap rate.

Settlement: If the specified Market Index is above the Cap rate, the seller pays the buyer, the difference in interest cost, else nothing is payable by the seller of the cap.

In the given case the seller of the cap is the bank.

The notional principal is $ 50 Million.

The Interest rate cap is with a ceiling of 12 %.

The current Interest rate represented by Market index is LIBOR = 9 %.

Since the Market Index, i.e., LIBOR of 9 %, does not exceed the ceiling or cap of 12 %, the bank is not required to pay any amount after one year.

If the LIBOR at the end of year one was say 14 %, then the bank would have to pay the 2 % interest that exceeds the Interest ceiling rate.

Thus since the market Index which is LIBOR does not exceed the Interest rate ceiling, the bank does not make any payment at the end of year 1.

Thus the answer to the question is option C = $ 0.