What is an over-the-counter cap option?
An over-the-counter cap option is a special kind of contract. It gives the person who buys it the choice to buy a cap at a set price. This set price is called the strike price.
Key features of over-the-counter cap options
Over-the-counter cap options have some important features:
- They are not traded on regular option exchanges. Instead, they are private deals made directly between two people or companies.
- The buyer and seller work out the exact terms of the option contract themselves. Things like the strike price, expiration date, and underlying cap are all chosen by them.
- Most of the time, over-the-counter options are customized to meet the specific needs of the buyer. This is different from standard exchange-traded options.
How do over-the-counter cap options work?
Let’s say a company thinks interest rates might go up in the future. Rising rates could make it more costly for them to borrow money. The company wants to protect itself against this risk.
Entering into an OTC cap option
The company could buy an over-the-counter cap option from a bank. The company and the bank would agree on:
- The interest rate level that will be the “cap” or upper limit
- The notional amount of the loan or debt
- The time period the cap option will cover
- The premium or price the company will pay the bank for the option
Now the company has the right, but not the obligation, to exercise the option and “buy” the interest rate cap if rates rise above the agreed level.
If interest rates stay low
Imagine rates stay below the cap level. The cap option will expire without being used. The company paid the premium to the bank for protection it ended up not needing. It lost money on the option, but rates stayed manageable.
If interest rates rise
Now picture rates going up past the cap level. The company will exercise its option. The bank must pay the company the difference between actual interest rates and the cap rate on the notional amount.
This payment compensates the company for the higher interest it must pay on its loans. The company’s borrowing costs are effectively capped. The premium it paid for the option was worthwhile.
Why do companies use over-the-counter cap options?
There are a few key reasons companies like using over-the-counter cap options:
Customization
Exchange-traded options come in standard sizes and with set terms. But companies can tailor over-the-counter options to match the size and time frame of a specific loan or project. This customization is a big advantage.
Hedging interest rate risk
Interest rates can be unpredictable. If a company has variable-rate debt, its borrowing costs could suddenly jump if rates rise. Buying a cap option is like buying insurance against this scenario.
No need to adjust underlying loans
The company doesn’t have to refinance its existing debt to get a fixed rate. It can keep the variable-rate loan and use the cap option to achieve a similar effect if needed. There’s more flexibility.
Downsides of over-the-counter cap options
While cap options have benefits, there are also some drawbacks companies must consider:
Cost
Option premiums are an added upfront cost. The company must pay for the option even if rates never rise and it doesn’t need the protection. It’s a sunk cost that can’t be recovered.
Counterparty risk
Over-the-counter options expose the company to the risk that the bank won’t pay up if the option is exercised. If the bank goes bust, the company could be left unhedged. Exchange-traded options don’t have this issue.
Complexity
Pricing over-the-counter options is tricky. The company must rely on the bank to give it a fair deal. The customized features also make the options harder to understand than plain vanilla instruments.
