The intrinsic value of interest rate caps
Hedging and Capital Markets
Real Estate | Kennett Square, PA
The upfront costs of interest rate caps have increased significantly in the past six months as short-term rates have risen and expected payouts on these caps have increased in probability and amount. This piece analyzes how cap pricing in the USD interest rate market factors-in expected future payouts and identifies that a meaningful portion of what a cap purchaser pays for upfront may reflect future payments they’ll receive back from the cap if rates follow the forward curve.
- Cap pricing has increased significantly over the past six months as a result of increases in current and expected future short-term rates and market volatility.
- Cap pricing can be split into two components: intrinsic value (NPV of payments) and time/option value (possibility that actual rates may exceed rate expectations at cap's purchase leading to payments to the cap purchaser that are higher than expected).
- For many cap structures, the intrinsic value component of cap pricing has driven much of the overall increase in cap costs over the past six months.
- This suggests that cap purchasers may expect to “receive back” some of what they paid for the cap in the form of payments from the cap provider if actual rates follow the prevailing forward curve at the time of cap purchase.
It’s helpful to remember that the value of a cap (and other option products, for that matter) can be broken down into two components: intrinsic value and time (or option) value. The intrinsic value of a cap reflects the present value of the payments that the borrower is expected to receive on the cap, based on market expectations for where the hedged index (typically SOFR or LIBOR) will go over the life of the cap. The time (or option) value of the cap captures the possibility that market expectations may be wrong and actual rates may be higher than currently priced in, driving a higher-than-expected series of payouts on the cap. Generally, caps with lower strike rates relative to current market expectations will have premiums that are driven relatively more by intrinsic value and less by time value, while caps with higher strike rates will be driven more by time value.
Let’s put this in the context of the cap pricing changes we’ve seen recently. Six months ago, a two-year cap on SOFR for a $50M loan with a 2% strike (i.e., the cap would pay the borrower if SOFR increased above 2%) would have been ~$85K. Of that $85K, $5K would have been dealer bid-ask spread/profit and the remaining $80K was entirely time value. No portion of the cap cost was due to intrinsic value, which makes sense when you look at the forward curve for SOFR below relative to the 2% strike rate. The market was pricing-in that SOFR was not going to go much higher than 1% over the coming two years (much less the 2% required for the cap to payout). A borrower purchasing the cap knew that actual rates might go higher than what the market expected (market expectations are rarely good predictors of what will actually occur), but based on market “expectations”, the cap wasn’t going to pay out. If the borrower wanted to underwrite actual rates following the forward curve, they might reasonably conclude paying for the cap was just throwing money away, as they would not expect to ever receive a payment on the cap.
Please reach out to us as you’re looking to purchase interest rate caps. In addition to pricing up a cap, we’re always happy to describe in more detail how the cap cost breaks down into the different components of intrinsic and option value and give you a sense of how much you might receive in payment on the cap based on the current forward curve.
Do you have more questions on how cap pricing has changed?
Schedule a call with one of our advisors today.
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.22-0133
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