A company that has borrowed at a floating rate — say, SONIA plus a credit spread — faces the risk that rates rise sharply, increasing its interest costs. It has several ways to manage this. It could enter an interest rate swap to pay fixed and receive floating, converting its borrowing to a synthetic fixed rate. But this eliminates the benefit if rates fall. Instead, the company may prefer to buy an interest rate cap — the right, but not the obligation, to limit its floating rate cost to a maximum level.
Interest Rate Caps
An interest rate cap is a series of individual interest rate options called caplets, each covering one interest period. If a company has a five-year floating-rate loan resetting quarterly, a five-year cap with 20 quarterly caplets limits the rate on each quarterly period to the cap strike rate.
At each reset date, if the prevailing floating rate (e.g., the three-month compounded SONIA rate) exceeds the cap strike, the caplet pays the borrower the difference: notional × (SONIA − cap strike) × (days/360). If SONIA is below the cap strike, the caplet expires worthless. The borrower has effectively capped their funding cost at the cap strike rate, while paying an upfront premium for the cap.
For example, a company with a £50 million, five-year floating-rate facility at SONIA + 150bp buys a 5% cap. If SONIA rises to 6%, each caplet pays out 100bp per period on the notional. The company's effective funding cost is capped at 5.00% + 150bp = 6.50%, regardless of how far SONIA rises above 5%.
Interest Rate Floors
A floor is the mirror image of a cap — a series of floorlets, each paying out if the floating rate falls below the strike. Floors are used by investors in floating-rate assets (such as banks with floating-rate loan books) who want to protect their income if rates fall. A bank with £500 million of floating-rate mortgages might buy a floor at 2% SONIA to ensure a minimum net interest income even in a low-rate environment.
Floors are also embedded in many structured products: a bond that pays the greater of 0% and the three-month rate effectively contains a floorlet at 0% for each period — the issuer has sold a floor to the investor, who is protected from negative rates.
Collars
A collar combines buying a cap and selling a floor at a lower strike. The premium received from selling the floor offsets part or all of the cap premium — making the collar cheaper or potentially zero-cost ("zero-premium collar"). In a zero-premium collar, the company accepts that if rates fall below the floor strike, it pays out on the floor (i.e., it doesn't benefit from rates falling below that level) in exchange for receiving the cap protection at no upfront cost.
Collars are popular with corporate treasurers who want to hedge rate risk but have no budget for an upfront premium. The trade-off is that the floor sale limits the benefit of a rate fall.
Caps vs Swaptions: What's the Difference?
Both caps and swaptions are interest rate options, but they hedge different exposures:
- A cap hedges the rate on individual floating-rate reset periods. It protects period by period, so it is ideal for borrowers who want to hedge each quarterly or semi-annual reset independently.
- A swaption hedges the present value of an entire swap at a future point in time. It is better for hedging the risk of entering a long-dated fixed-rate swap at a future date — for example, a company planning to refinance a maturing loan with a ten-year fixed-rate bond in twelve months.
A cap on a ten-year floating-rate loan is mathematically a portfolio of 40 quarterly caplets (if quarterly). A swaption on a ten-year swap is a single option on the par swap rate at the expiry date. The cap and swaption vol markets are related — they must be consistent with each other in theory — but they trade differently and are quoted in different conventions.
Black Model Pricing
Caplets, floorlets, and European swaptions are all priced using the Black model. For a caplet, the Black formula treats the forward rate for the period as a lognormally distributed variable (under the lognormal convention) or normally distributed (under the Bachelier/normal vol convention). The key inputs are:
- Forward rate for the period (derived from the curve)
- Cap strike rate
- Time to the start of the period (the "expiry")
- Implied volatility
- Discount factor for the payment date
The cap premium is then the sum of all caplet premiums across the life of the instrument.
Vol Quoting Conventions: Normal vs Lognormal
Historically, caps and swaptions were quoted in lognormal (Black) volatility: the vol parameter in the standard Black model. A 1y5y lognormal swaption vol of 30% meant the one-year expiry into five-year underlying swaption used 30% as the annual standard deviation of the log-change in the forward swap rate.
When rates approached zero and turned negative after 2014 in the Eurozone and Japan, lognormal vol became problematic — you cannot take the log of a negative number. The market shifted to normal (Bachelier) volatility, which assumes rate changes (not returns) are normally distributed. Normal vol of 80bp means the annualised standard deviation of absolute rate changes is 80 basis points. Both conventions remain in use across different markets, and quoting screens will specify which applies.
Delta Hedging Caps and Floors
Rates desks that sell caps or floors to clients must manage the resulting options risk. The primary risk metric is delta — the sensitivity of the cap's value to a parallel shift in interest rates. A cap delta is positive for the buyer (the cap gains value as rates rise toward and above the strike) and negative for the seller. The dealer hedges delta by taking an offsetting position in interest rate swaps, adjusted as rates move. As each caplet approaches its fixing date, the delta behaviour becomes more binary — the caplet is either in or out of the money — and the gamma (rate of change of delta) can be large, requiring frequent re-hedging.