Current IssueFebruary 2006

How can your institution protect itself from declining rates and, at the same time, procure a reliable source of term funding that helps to protect from rising rates? This month, the Seattle Bank will introduce a series of capped, floating-rate advance structures, that can allow you to:

- Protect against adverse movements in interest rates
- Benefit from lower borrowing costs if interest rates decline
- Emulate the flexible benefits of the capped, floating-rate funding structure to your customers

The payment for each period is determined by comparing the current level of the index interest with the cap rate. If the index rate exceeds the cap rate, the payment is calculated as a function of the difference between the two rates, the length of the period, and the notional amount of the contract. If the index rate is below the cap rate, no payment is made, reflecting the asymmetrical payoff options. The buyer of a cap has a position that is similar to that of a buyer of a call on an interest rate, both of whom benefit when interest rates rise.

Caps are frequently purchased by issuers of floating-rate debt who wish to protect themselves from the increased financing costs associated with an increase in interest rates. While the cap protects the borrower from an increase in interest rates, the floating rate allows the member to benefit from a decline in interest rates. Seattle Bank members can take advantage of these derivative instruments by embedding these options into advances. An advance with an embedded cap can help with managing interest-rate risk, funding loans in portfolio, and meeting asset/liability management objectives.

Mechanically, a capped, floating-rate advance is structured with a known spread over an index, most likely 3-month LIBOR, with the rate of the index capped at an appropriate level. For example, table 1 illustrates the terms for a hypothetical floating-rate advance:

Index | 3-month LIBOR |
---|---|

Spread |
+ 42 bps |

Cap Rate |
5.50% |

Term |
3 years |

Our hypothetical advance has a final maturity of three years, and there are no call/put provisions. Because the index is 3-month LIBOR, payments will be made quarterly, and the rate on the advance will adjust every three months to the current 3-month LIBOR rate plus the stated spread of 42 basis points. In the event three-month LIBOR exceeds 5.50% on one of the reset dates, the index will be capped at 5.50%. Thus the advance rate will be capped at 5.92% (i.e., the index cap plus the spread; in this case 5.50% + 0.42% = 5.92%). For example, if a member holds a $5-million advance with these terms and 3-month LIBOR increases to 6.50% on the observation date, the rate on the advance would hold at 5.92%, resulting in a payment of $74,000.

Let’s compare the mechanics of the capped floating-rate advance to another liability set at 3-month LIBOR and hedged with a cap purchased (in derivative form) at 5.50%. The periodic payment on the cap can be calculated as follows:

= Max ( 0, (notional principal) * (index rate – cap strike) * (Act / 360))

What would be the rate on the liability if 3-month LIBOR climbs to 6.50%? As shown in Table 2, the net cost of the liability and off-balance sheet derivative would be identical to the capped floating-rate advance with similar terms. Both result in a hedge against rising interest rates.

Liability @ 6.50% on principal of $5 million | ($81,250.00) |
---|---|

Cap payment on notional amount of $5 million |
$12,500.00 |

Cost of cap / payment period |
($5,250.00) |

Net cost of liability |
($74,000.00) |

Please note that it is the index rate, not the advance rate, that is capped.

**Valuing Caps
**When determining the value of a cap, it’s important to view the cap as a composition of a number of options, as opposed to just one single option. A cap is really composed of a number of interest rate call options, with expirations spanning from the first payment date until maturity. The component options are called caplets. Each caplet is distinct in having its own expiration date, but typically the exercise rate on each caplet is the same.

Why are we talking about caplets? They represent the discounted sum of the parts that compose the value of the cap. Without getting into too much detail on the world of option valuation, let’s focus on two variables that affect the value of caplets:

- The first, of course, is the interest rate on the underlying index. In general, as interest rates rise or the curve steepens, the value of the option will increase due to the increased likelihood that the options will be “in-the-money.”
- Second is volatility. If volatility increases, holding everything else constant, the value of the option will increase as well. Why? If interest rates are more volatile, there is a greater probability that the options will be in-the-money.

As illustrated in Figure 1, volatility has declined significantly over the past three years. With the decreasing probability that an option will be in the money (due to less volatile interest rate movements), the cost of an option is going to be less than it would have been during the past three years.

Further, the shape of the yield curve is dramatically different than it was two or three years ago. As shown in Figure 2, below, the U.S. Treasury yield curve has flattened substantially over the past three years. There are a variety of factors driving the shape of today’s yield curve, which inverts by several basis points between the two- and 10-year points:

- The Fed’s success in keeping inflation subdued and stable has resulted in a decline in the premium investors require to invest in longer maturity assets. Thus, the yields on longer-term treasuries have been pushed down.
- The surplus of capital in the global markets, which needs to be invested, has resulted in increased demand for U.S.-denominated assets and, hence, has provided firm support for prices of U.S. assets.

Aside from technical variables, the yield curve should also be a product of economic fundamentals. Accordingly, under normal circumstances, a flat yield curve should tell us that forecasted growth will be subdued and inflation benign.

What are the implications for the capped, floating-rate advance product? It’s safe to say that a steeper yield curve implies a higher probability that a short-term rate index, such as 3-month LIBOR, will surpass the cap rate. With the curve as flat as it is, the forward curve for 3-month LIBOR is extremely flat. Thus, the cost of purchasing the option (cap) on the index is relatively low.

The factors discussed above account for the dollar cost of a cap in today’s environment being less than it would have been for much of the past three to four years.

The capped advance provides protection for a rise in interest rates and, at the same time, positions the holder to benefit from a decline in rates. The structure can also provide greater flexibility as a method for passing capped loans through to your customers. Of course, the structure should be considered in the context of the overall balance sheet. With market conditions producing a low premium for purchasing options on interest rates, this could be an appropriate time to consider embedding a long position in a cap into an advance.

Erick Rendon is a Business Development Analyst at the Federal Home Loan Bank of Seattle.