Question

How is the premium of an interest rate cap calculated?

Answer 1

First of all we shall understand the meaning of interest rate cap

Suppose a firm needs to borrow money at floating rate of interest (variable rate of interest) and it is afraid that the interest rate in future might increase. In this situation the firm to protect itself against rise in interest rate in future would buy the interest rate cap. For this contract the firm would be making payment which is known as premium (to be paid in advance).

These contracts can be settled monthly, quarterly, yearly.

The formula to calculate the premium of interest rate is :

INTEREST RATE (index or reference interest rate eg. LIBOR) - CAP RATE * ACTUAL DAYS/360 * NOTIONAL AMOUNT

For example if a firm has entered in to a contract where CAP rate is 7% for $10,000. Lets say after 3 months the payment would be settled, at that point of time the rate in market is going as 8%. Now the benefit to the buyer would be as follows:

8% - 7% * 90/360 * $10000 = $25.

So the benefit to the buyer would be 25$.  

I hope it would help. Feel free to ask in case of any queries