Case 012Rates and hedgingWarm up

Ekavira Malls buys a three-year 9% interest rate cap on Rs 500 crore of floating debt for a 1% upfront premium. If the benchmark goes to 10.5% for a year, what does the cap pay, and at what rate does it break even?

The situation

Ekavira Malls owns two shopping centres financed with Rs 500 crore of floating-rate debt at the benchmark rate plus 2.25%, reset once a year. The benchmark is 8.0% today. Its lenders want protection against a rate spike, so Ekavira buys a three-year interest rate cap with a strike of 9% on the full Rs 500 crore, paying a premium of 1%, Rs 5 crore, up front.

Assume the cap settles once a year on that year's benchmark, and ignore discounting.

Your task

Work out what the cap pays if the benchmark is 10.5% for a year, where the cap breaks even, and what it does to Ekavira's worst-case borrowing cost.

Quick check

The benchmark is 10.5% for one year. What does the cap pay that year?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

At 10.5% the cap pays Rs 7.5 crore for that year, more than the Rs 5 crore premium. It breaks even if the benchmark averages about 9.33% across all three years, or reaches 10% in a single year with the others below the strike. It caps Ekavira's rate at 11.25% plus about 0.33% a year of premium, whatever the benchmark does.

Step 1What does a cap actually do?

It is insurance on your interest bill. Car insurance with an excess pays nothing for a scratch, then pays for everything above the excess once the damage is large. An interest rate capAn option that pays the holder the difference between a floating rate and a set strike rate, on a notional amount, whenever the floating rate is above the strike. pays nothing while the benchmark is below the strike and pays the difference above it, on the notional, for each settlement period. Ekavira keeps paying its floating rate to lenders; the cap sends back whatever is above 9%.

Step 2What does it pay at 10.5%, and what is Ekavira's cost that year?

The excess over the strike is 1.5%, and 1.5% of Rs 500 crore is Rs 7.5 crore. Ekavira pays its lenders 10.5% plus 2.25%, 12.75%, and receives 1.5% from the cap, so its net rate is 11.25%, exactly the strike plus its margin. Add the premium spread over three years, about 0.33% a year, and the worst-case cost is about 11.58% however high the benchmark goes.

A cap pays nothing until the strike, then Rs 5 crore per point-5+5+100strike 9%10.5%: pays Rs 7.5 crorenet zero at 9.33% each yearpremium, about Rs 1.67 crore a yearcap payoffafter premiumRs crore in one year7%8%10%11%
The 9% cap on Rs 500 crore pays nothing below the strike and Rs 5 crore for every point above it, so a 10.5% year pays Rs 7.5 crore; after about Rs 1.67 crore a year of premium, the cap is ahead in any year the benchmark averages above about 9.33%.
Step 3Where does the cap break even?

It depends on how the rates arrive, so give both versions. If rates spike in only one year, the cap must pay Rs 5 crore that year, which needs a benchmark of 10%; if the rate sits above the strike all three years, it only needs to average about 9.33%. Both ignore discounting, which pushes the break-even slightly higher because the premium is paid today and the payouts come later.

The relationship
payofft=N×max⁡(rt−K, 0)500×(10.5%−9%)=7.5\text{payoff}_t = N \times \max(r_t - K,\,0) \qquad 500 \times (10.5\% - 9\%) = 7.5
Nthe notional, Rs 500 crore
r_tthe benchmark in year t
Kthe strike, 9%
What it says in wordsEach year the cap pays the notional times whatever the benchmark exceeds the strike by, and nothing if it does not.
Step 4Is it worth buying if rates never reach 9%?

That is the wrong test for insurance. A cap is judged by what it removes, not by whether it pays out: it turns an open-ended interest bill into a known maximum, for a known premium. For a mall owner whose rent roll is fixed for years, that ceiling protects the equity and keeps interest cover above the lenders' tests. The limitation is cost: a cap closer to today's rate protects more and costs more, and the premium is gone whether or not rates rise.

Where candidates lose it

The common miss is applying the whole 10.5% to the notional and saying the cap pays Rs 52.5 crore. It pays only the excess over the strike.

The second is quoting 10% as the break-even without saying it assumes all the payout comes in one year. If rates sit above the strike for the whole term, a much smaller excess covers the premium.

What the interviewer asks next

  • How would the premium change for an 8.5% strike?
  • What is an interest rate collar, and why might Ekavira sell a floor to pay for the cap?
  • Why might a lender require a cap rather than a swap?

Company names and figures are illustrative.