Interest Rate Caps & Floors

1. Core Product Concepts

Interest rate caps and floors are important OTC derivatives that have become effective tools for managing benchmark rate fluctuations (e.g., LPR/SHIBOR) amid China's interest rate liberalization. These products use financial engineering to contain interest rate risks within predefined ranges, primarily categorized as:

1. Interest Rate Cap: A series of European call options (Caplets) that compensate the buyer when reference rates exceed the strike rate. Typically used by floating-rate borrowers to hedge against rate hikes.

2. Interest Rate Floor: Composed of European put options (Floorlets) that trigger compensation when reference rates fall below the strike. Mainly utilized by investors seeking minimum yield protection.

3. Interest Rate Collar: Combines long cap and short floor positions to create an interest rate band, balancing hedging costs and risk protection.

2. Application Scenarios

(1) Case Studies

Case 1: Airline Interest Rate Hedge

• Background: China Eastern Airlines' 500M RMB floating-rate loan linked to 6M SHIBOR
• Action: Purchased 4% strike cap for 500,000 RMB premium
• Results:
  • Compensation received when SHIBOR exceeds 4%
  • Total interest savings: 25,000 + 87,500 = 112,500 RMB
  • Maximum single-period protection: Reduces effective rate from 4.35% to 4%

Cash Flow Analysis:

Date	SHIBOR	Interest Due	Cap Compensation	Net Cash Flow	Unhedged Cash Flow
Init	3.85%	-	-500,000	49.5M	50M
6M	3.80%	950,000	0	-950,000	-950,000
12M	4.10%	1,025,000	25,000	-1,000,000	-1,025,000
18M	4.35%	1,087,500	87,500	-1,000,000	-1,087,500
Maturity	-	-	-	-50M	-50M

Key Formula:
Periodic compensation = 50M × max(0, SHIBOR - 4%) × days/360

Case 2: Money Fund Yield Protection

• Portfolio: 1B RMB floating-rate bonds
• Strategy: Purchased 2.5% floor
• Results:
  • Quarterly compensation of 375,000 RMB when SHIBOR falls to 2.2%
  • Ensures minimum portfolio yield

(2) Institutional Applications

Institution Type	Risk Exposure	Suitable Product	Typical Operation
Property Developers	Floating-rate loan risk	Cap	Purchase LPR-linked cap
LGFVs	Debt cost volatility	Collar	Construct 3.5%-5% rate corridor
Money Funds	Investment yield decline	Floor	Buy SHIBOR floor
Commercial Banks	NIM compression	Cap+Floor combo	Two-way ALM hedge

3. Pricing Models & Technical Analysis

(1) Black Model Framework

Cap Pricing Formula:

$$V_{cap} = N\sum_{i} P(0,T_i)τ_i[FΦ(d_1)-KΦ(d_2)]$$

Floor Pricing Formula:

$$V_{floor} = N\sum_{i} P(0,T_i)τ_i[KΦ(-d_2)-FΦ(-d_1)]$$

Where:

$$d_1 = \frac{\ln(F/K)+σ^2T/2}{σ\sqrt{T}}, \quad d_2 = d_1 - σ\sqrt{T}$$

(2) RMB Market Features

1. Volatility Surface: Policy-sensitive, 1Y implied vol typically 15-25%
2. Term Structure: Short-term (<1Y) liquidity premium 10-15bp, long-term (>3Y) 20-30bp
3. Basis Risk: Must monitor LPR-SHIBOR correlation

(3) Valuation Practices

1. Parameter Sourcing:
   • Discount curve: Sovereign yield curve-based
   • Forward rates: SHIBOR/LPR forward contracts
   • Volatility: Third-party vendors (Bloomberg/Refinitiv) or market quotes

4. Market Trends & Developments

(1) Current Landscape

• Participants: Commercial banks (65%), corporates (25%), non-banks (10%)
• Trading Volume: 580B RMB notional in 2022
• Tenor Distribution: <1Y (75%), 1-3Y (20%), >3Y (5%
  With RMB internationalization and rate reform deepening, the market is projected to exceed 1 trillion RMB within 3 years. Participants should leverage these derivatives to optimize risk management and enhance financial stability.