A company caps 3-month LIBOR at 2 % per annum. The principal...

A company caps 3-month LIBOR at $2 \%$ per annum. The principal amount is $$\$ 20$$ million. On a reset date, 3-month LIBOR is $4 \%$ per annum. What payment would this lead to under the cap? When would the payment be made?

Key Concepts

Reset Date and Payment Date

The reset date is the date on which the reference rate (LIBOR) is observed and compared against the cap strike rate to determine if a payout is due. However, the payment under a cap typically occurs at the end of the accrual period following the reset date. This delay allows for the proper calculation of interest over the period and is standard practice in interest rate derivative contracts.

Interest Rate Cap

An interest rate cap is a derivative contract that sets a maximum (or strike) interest rate on a notional amount for a specified period. It provides protection to the buyer against rising interest rates by paying the difference when the reference rate, such as LIBOR, exceeds the cap rate. This instrument is widely used by borrowers to hedge against interest rate volatility.

LIBOR

LIBOR, or the London Interbank Offered Rate, is a benchmark rate at which major global banks lend to one another in the international interbank market for short-term loans. It is commonly used as a reference interest rate for a wide variety of financial instruments, including interest rate caps, loans, and derivatives.

Cap Payment Calculation

The cap payout is calculated based on the difference between the actual reference rate (in this case, LIBOR) and the cap strike rate, applied to the notional principal over the accrual period. Specifically, if the actual rate exceeds the cap rate, the payment is determined by multiplying the rate differential by the notional principal and adjusting for the period (for example, using a quarter-year fraction for a 3-month period).

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