A capped swap is an interest rate swap with an interest rate cap option where the floating rate of the swap is capped at a certain level while a floored swap is an interest rate swap with a floor option where the floating rate of the swap is floored at a certain level. Capped swaps or floored swaps limit the risk of the floating rate payer or receiver to adverse movements in interest rates. A capped swap can be decomposed into a swap and a cap whereas a floored swap can be decomposed into a swap and a floor.
This presentation gives an overview of capped/floored swap product and valuation.
3. Capped Swap
Capped Swap Definition
โ A capped swap is an interest rate swap with a cap where the floating
rate of the swap is capped at a certain level.
โ It limits the risk of the floating rate payer to adverse movements in
interest rates.
โ Given the optionality, an up-front fee or premium has to be paid by the
floating rate payer.
โ A capped swap can be decomposed as an interest rate swap plus an
interest rate cap.
4. Capped Swap
Floored Swap Definition
โ A floored swap is an interest rate swap with a floor where the floating
rate of the swap is floored at a certain level.
โ It limits the risk of the floating rate receiver to adverse movements in
interest rates.
โ Given the optionality, an up-front fee or premium has to be paid by the
floating rate receiver.
โ A floored swap can be decomposed as an interest rate swap plus an
interest rate floor.
5. Capped Swap
Valuation
โ There are four types of capped or floored swaps.
โ Capped payer swap
โ Capped receiver swap
โ Floored payer swap
โ Floored receiver swap
โ The present value of a capped payer swap is given by
๐๐๐ถ๐๐๐๐๐๐๐๐ฆ๐๐๐๐ค๐๐ ๐ก = ๐๐๐๐๐๐๐ก ๐ก โ ๐๐๐๐๐ฅ๐๐ ๐ก โ ๐๐๐๐๐(๐ก)
where
๐๐๐๐๐๐๐ก is the present value of the floating leg of the underlying swap;
๐๐๐๐๐ฅ๐๐ is the present value of the fixed leg of the underlying swap;
๐๐๐๐๐ is the present value of the embedded cap.
6. Capped Swap
Valuation (Cont)
โ The present value of a capped receiver swap can be expressed as
๐๐๐ถ๐๐๐๐๐๐ ๐๐๐๐๐ฃ๐๐๐๐ค๐๐ ๐ก = ๐๐๐๐๐ฅ๐๐ ๐ก โ ๐๐๐๐๐๐๐ก ๐ก + ๐๐๐๐๐(๐ก)
โ The present value of a floored payer swap can be represented as
๐๐๐น๐๐๐๐๐๐๐๐๐ฆ๐๐๐๐ค๐๐ ๐ก = ๐๐๐๐๐๐๐ก ๐ก โ ๐๐๐๐๐ฅ๐๐ ๐ก + ๐๐๐๐๐๐๐(๐ก)
Where ๐๐๐๐๐๐๐ is the present value of the embedded floor.
โ The present value of a floored receiver swap can be computed as
๐๐๐น๐๐๐๐๐๐๐ ๐๐๐๐๐ฃ๐๐๐๐ค๐๐ ๐ก = ๐๐๐๐๐ฅ๐๐ ๐ก โ ๐๐๐๐๐๐๐ก ๐ก โ ๐๐๐๐๐๐๐(๐ก)
7. Capped Swap
Valuation (Cont)
โ The present value of the fixed leg is given by
๐๐๐๐๐ฅ๐๐ ๐ก = ๐ ๐ ๐๐ ๐ท๐
๐
๐=1
where R โ the fixed rate; N โ the notional; ๐๐ โ the day count fraction for period
[๐๐โ1, ๐๐]; ๐ท๐ = ๐ท(๐ก, ๐๐) โ the discount factor.
โ The present value of the floating leg is given by
๐๐๐๐๐๐๐ก ๐ก = ๐ (๐น๐ + ๐ )๐๐ ๐ท๐
๐
๐=1
where s โ the floating spread; ๐น๐ = ๐น ๐ก; ๐๐โ1, ๐๐ =
1
๐๐
๐ท ๐โ1
๐ท ๐
โ 1 โ the simply
compounded forward rate
8. Capped Swap
Valuation (Cont)
โ The present value of the cap is given by
๐๐๐๐๐ ๐ก = ๐ ๐๐ ๐ท๐ ๐น๐ฮฆ ๐1 โ ๐พฮฆ(๐2)
๐
๐=1
where ๐1,2 = ln
๐น๐
๐พ
ยฑ 0.5๐๐
2
๐๐ /(๐๐ ๐๐) and ฮฆ โ the cumulative normal
distribution function.
โ The present value of the floor is given by
๐๐๐๐๐ ๐ก = ๐ ๐๐ ๐ท๐ ๐พฮฆ โ๐2 โ ๐น๐ฮฆ โ๐1
๐
๐=1
9. Capped Swap
A real world example
Cap/Floor specification Underlying swap specification
Buy Sell Buy Leg 1 Leg 2
Cap Floor Floor Currency USD Currency USD
Strike 0.001 Day Count dcAct360 Day Count dcAct360
Trade Date 11/3/2016 Leg Type Fixed Leg Type Float
Start Date 11/4/2016 Notional 200000000 Notional 200000000
Maturity Date 11/2/2020 Payment Freq 1M Payment Freq 1M
Currency USD Pay Receive Pay Pay Receive Receive
Day Count dcAct360 Star tDate 11/4/2016 Start Date 11/4/2016
Notional 200000000 End Date 11/1/2020 End Date 11/1/2020
Pay Receive Receive Fixed Rate 0.01043 Spread 0
Payment Freq 1M Index specification
Index specification Type LIBOR
Day count dcAct360 Tenor 1M
Tenor 1M Day Count dcAct360
Type LIBOR