Interest rate risk and cap risk

CFA Level III
#1

Gentlemen,

context : CFAI refers to three main risks fix income ptf are subject to in the event of interest rate changes :

  1. Interest rate risk

  2. cap risk

  3. Contingent claims risk (negative convexity)

some practical examples how to differentiate and clearly spot Interest rate risk and cap risk cause both of them refer to floaters?

thanks

#2

Interest rate risk is affects all of them, but not equally.

Cap risk is exclusively to floating bonds, if you are on the long end.

#3

Thanks Mr Smart.

Cap risk should be around the floating bonds whose Price is capped ? (Any example? Callable? )

In other words if I am not sure Interest rate risk roughly should be mostly present ?

#4

Cap risk caps the floating rate, not the price. It does the opposite to price for a floater, the price goes below par, even at market resets.

Interest rate risk just generally means interest rates moving against you (typically up), which is also a problem for a floater if a cap is embedded.

It can also move against you if your bond is callable, then drops in interest rate caps the price, and eventually takes it from you.

#5

Just as an aside…Caps and Floors needn’t be necessary for floaters but are preferable as a hedge against floaters. For ex: ABC can issue a 10y fixed bond callable after 5yrs/even non callable and say a year later the environment for a falling rate comes up unfortunately. ABC could hedge this buying a floor or selling a cap to generate excess returns. In the event that they expect rates to rise, they could buy a cap not as a hedge but to make more money if rates eventually go up.

#6

Hi

Since floating rates are capped what are the repucussions on bond price and why ??

What i understood is that even though rate increase is capped price will fall drastically …If i am correct then please tell why this happens and what more i am missing with cap risk as far its effect on bond prices are concerned?

#7

If the interest rate is capped, then the market interest rate can move way above the reset rate, putting the bond at a discount.

#8

Issue a floating bond, pay L. Buy a cap, pay X receive L if exercised (although the cap gives the payoff). Splitting it up, this is how it looks: -L-K+L= -K. It’s like a fixed rate bond exposure where the price falls if rates go up. If a PM with a floating rate liability invests in a floating rate bond that has a cap, the PM is at risk. The liability will reprice to par as the coupon payment resets. But when the asset is capped and interest rates rises above the cap rate, the coupons/cash flows will be fixed by the cap: - Coupon received will be lower than coupon paid - While the liability will be repriced to par due to the reset, the asset will be repriced downwards because the floating rate note has been effectively converted to a fixed rate note (at the cap rate) and experience a downward pricing - duration.

#9

thanks,

when you say “Buy a cap” can I deem the cap as long swap payer (I pay fix and receive floating) ?

#10

You mean a swaption?

No, you’re still being compensated with a floating rate. That reduces the net payment overall.

#11

Agree Mr Smart (I mean swap or swaption whatsoever) but the net impact of the structure described by

AmruthSundarkumar Seems to configure a swap structure in my eyes. thanks