Guide

# Interest rate cap payout mechanics

### Summary

An interest rate cap is an insurance policy on a floating-rate index like SOFR, LIBOR, SONIA, or EURIBOR. It pays out to the purchaser of the cap if the index rate increases above a pre-determined threshold (the “strike rate”). When this happens, the cap is considered “in-the-money.” Once a cap becomes in-the-money, the cap provider will make monthly payments to compensate the cap owner for the difference between the cap strike rate and where the underlying index resets each period. This guide reviews the mechanics of this payout calculation using the example of a \$50M cap on SOFR with a strike rate of 0.50% and a 1-year term.

### Cap payout calculations

For a cap of this structure, at any point SOFR resets above 0.50%, the cap will payout based on the difference between the market rate and 0.50%.

Using the example above, the cap will payout in its fifth month, with the payment calculated using the formula below:

Cap payout = (Monthly day count fraction) x (Notional amount) x (Index rate – cap strike)

\$11,194.44 = (June 1, 2022 - May 1, 2022) / 360 x (\$50,000,000) x (0.76% - 0.50%)

This calculation will occur each period throughout the life of the interest rate cap. Payouts for months six through 12 are not known until those rate resets occur.

### Cap payment details

Once a cap is expected to payout, it is essential to coordinate the appropriate wire instructions for where the funds should be sent. Most cap purchasers have not yet set-up these details, and may need to do so as follows:

• Lender-required cap: In the event the cap was a requirement of the loan and collaterally assigned to the lender, the borrower should reach out to their loan relationship manager, administrator, or servicer and ask where they would like the funds directed. Often, lenders will require the cap payments to be sent to a separate lockbox account controlled by the lender. Depending on the specific lender, the cap payments may be netted against the interest owed on the underlying loan, or the lender may request full upfront loan interest payments and provide a separate reimbursement to the borrower for the cap payment. While there are administrative differences, the economic result will be the same.
• Elective cap: In the event a cap was purchased electively and not collaterally assigned, the cap owner can provide their preferred payment instructions.

In shifting rate environments, many previously out-of-the-money caps may become in-the-money and start to pay out. The forward curve provides market implied pricing for future rate resets. Our Chatham Rates forward curve page shows multiple 10-year forward curve projections updated daily; though it should be cautioned that the forward curve has historically been a poor predictor of actual future rates. It’s recommended to compare the forward curve to current cap contract strike rates to see which caps are worth coordinating payment details for. We recommend reaching out to your Chatham representative in advance to coordinate the payment instructions for each individual cap and to discuss further if any questions arise.

## What is an interest rate cap?

An interest rate cap is essentially an insurance policy on a floating rate, most frequently SOFR. It has three primary economic terms: notional, term, and strike rate.

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### Disclaimers

Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.

Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.

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