Why do we buy a cap and sell a floor to hedge a floating rate liability and do the opposite for a floating rate asset(buy a floor and sell a cap). Can someone explain this intuitively, so if we have a liability to pay at 6%, and we want to position the amount we pay between 6 and 9%, we buy a floor cap with strike price of 6% and sell a floor at 9%? PLEASE HELP!! thanks!
Ok if you have a floating rate liability, you are making interest payments. You want to buy a cap, so that if interest rates go too high, you risk is limited. If rates go above the cap, your interest payments are lower than they otherside would have been. You sell a floor to help pay for the cost of the cap. If interest rates drop, the rate will hit the floor and you are paying a higher interest rate they you otherwise could have. Now as for your example, if you have a floating rate liability, that means interest payments will change based on how rates change. If rates are currently 6% and you don’t want to pay more than 9.0%, you will buy a cap at 9.0%. If interest rates jump up to lets say 10%, you will still only pay the 9% rate. You sell the floor at 6% to help pay for the cost. If interest rates drop to 5%, you still have to pay the rate of 6%.
Hi vinnie If you have a floating rate liability of 6% you would be concerned about rates going up (and having to pay more) so you may choose to buy a cap at say 9%. Therefore the floating rate would be capped at 9%. Likewise a floor would limit rates falling below a certain point, say 3%. As a floating rate payer you would benefit from rates falling as low as possible, so why would you want to introduce a floor? The reason is by selling the floor you help fund the cost of buying the cap. Definitions: * An interest rate cap is bundle of European call options (caplets) where the buyer receives a pay-off when the floating rate exceeds the strike price. * An interest rate floor is bundle of European put options (floorlets) where the buyer receives a pay-off when the floating rate is below the strike price. Hope the above helps.
Good Job…Job (too many jobs - sorry) I was going to get after this but you beat me to it! Just to be clear on where the cash flows come from: if int. rates are 10% on your floating liability: you pay 10% to the liability, but you receive 1% from cap since cap rate is 9% (10% - 9% = 1%) If int rates are 5%: you pay 5% on your floating liability AND pay 1% on your floor b/c you shorted the floor rate of 6% to ofset the costs of the cap. so your liability goes from assuming any int. rates and being at the mercy of the market, to having a minimum int rate of 6% to a maximum of 9%.
job71188 Wrote: ------------------------------------------------------- > Ok if you have a floating rate liability, you are > making interest payments. You want to buy a cap, > so that if interest rates go too high, you risk is > limited. If rates go above the cap, your interest > payments are lower than they otherside would have > been. You sell a floor to help pay for the cost of > the cap. If interest rates drop, the rate will hit > the floor and you are paying a higher interest > rate they you otherwise could have. > > Now as for your example, if you have a floating > rate liability, that means interest payments will > change based on how rates change. If rates are > currently 6% and you don’t want to pay more than > 9.0%, you will buy a cap at 9.0%. If interest > rates jump up to lets say 10%, you will still only > pay the 9% rate. > > You sell the floor at 6% to help pay for the cost. > If interest rates drop to 5%, you still have to > pay the rate of 6%. Good answer 
YOU GUYS ARE AWESOME!!!