CAP AND FLOOR AGREEMENTS There are agreements available in the financial market whereby one

CAP AND FLOOR AGREEMENTS There are agreements available in the financial market whereby one

party, for a fee (premium), agrees to compensate the other if a desig- nated reference is different from a predetermined level. The party that will receive payment if the designated reference differs from a predeter- mined level and pays a premium to enter into the agreement is called the buyer. The party that agrees to make the payment if the designated ref- erence differs from a predetermined level is called the seller.

When the seller agrees to pay the buyer if the designated reference exceeds a predetermined level, the agreement is referred to as a cap. The agreement is referred to as a floor when the seller agrees to pay the buyer if a designated reference falls below a predetermined level.

In a typical cap or floor, the designated reference is either an interest rate or commodity price. The predetermined level is called the exercise value. As with a swap, a cap and a floor have a notional amount. Only the buyer of a cap or a floor is exposed to counterparty risk.

In general, the payment made by the seller of the cap to the buyer on a specific date is determined by the relationship between the desig- nated reference and the exercise value. If the former is greater than the latter, then the seller pays the buyer an amount delivered as follows:

Notional amount × [Actual value of designated reference − Exercise value] If the designated reference is less than or equal to the exercise value,

then the seller pays the buyer nothing. For a floor, the payment made by the seller to the buyer on a specific date is determined as follows. If the designated reference is less than the exercise value, then the seller pays the buyer an amount delivered as fol- lows:

FOUNDATIONS

Notional amount × [Exercise value − Actual value of designated reference] If the designated reference is greater than or equal to the exercise value,

then the seller pays the buyer nothing. The following example illustrates how a cap works. Suppose that the FPK Bookbinders Company enters into a five-year cap agreement with Fleet Bank with a notional amount of $50 million. The terms of the cap specify that if one-year LIBOR exceeds 8% on December 31 each year for the next five years, Fleet Bank (the seller of the cap) will pay FPK Bookbinders Company the difference between 8% (the exercise value) and LIBOR (the designated reference). The fee or premium FPK Bookbinders Company agrees to pay Fleet Bank each year is $200,000.

The payment made by Fleet Bank to FPK Bookbinders Company on December 31 for the next five years based on LIBOR on that date will

be as follows. If one-year LIBOR is greater than 8%, then Fleet Bank pays $50 million × [Actual value of LIBOR − 8%]. If LIBOR is less than or equal to 8%, then Fleet Bank pays nothing.

So, for example, if LIBOR on December 31 of the first year of the cap is 10%, Fleet Bank pays FPK Bookbinders Company $1 million as shown below:

$50 million × [10% − 8%] = $1 million