CFA Level I · CFA Level I Exam · Forward Commitment and Contingent Claim Features and Instruments
A company borrows at a floating rate and buys an interest rate cap with a strike of 5%. At a settlement date the reference rate is 4%. The cap payoff to the company at that date is most likely:
The cap payoff is zero. A cap pays only when the reference rate exceeds the strike. Here 4% is below 5%, so the caplet expires worthless, and the buyer never pays more than the premium already paid, so no negative payoff arises.
- AZero, because the reference rate is below the strikeCorrect
- BPositive, equal to 1% of notional adjusted for the accrual period
- CNegative, equal to the 1% shortfall against the strike
Explanation
A cap is a series of interest rate call options that pay when the reference rate exceeds the strike. At 4% versus a 5% strike the caplet is out of the money and pays zero. The buyer's loss is limited to the premium, so a negative payoff cannot occur.
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