If you do not see the caps and floors options (described in the articles below) in your PrecisionLender account, please contact our support team to have this functionality enabled. Our client services group will then contact you and walk you through the setup process.
Setting Up Caps & Floors
Caps and Floors are configured in Administration. First, you must select a Cap and Floor approach, Maximum Cap Duration, and Volatility Method at the Region level. After that, you must select the Interpolation Method at the Funding Packages.
After selecting a Region, click the 'Edit' button in the upper left.
Next, scroll down to the 'Cap & Floor Options' header to begin setting up Caps & Floors for this region.
Setting up Caps and Floor consists of the following:
- Selecting a Cap and Floor Approach
- Setting Maximum Cap Duration (Optional)
- Setting up Volatility Method
- Setting the Interpolation Method
1. Selecting a Cap and Floor Approach
Prior to enabling Caps and Floors you need to decide which method you will utilize. The differences between methods are significant, and we encourage you to speak with our Client Success group if you need assistance in selecting a method.
The available methods and the suggested values are as follows:
Standard cap and floor method is the most simplistic and correspondingly the least reflective of the cost and impact of purchasing a cap or floor in the market. The Standard method only applies an impact to the opportunity if the cap or floor is In-The-Money, and in such cases uses the cap or floor rate to calculate finances of the opportunity. There is no impact on the ROE of the opportunity if the cap or floor is out-of-the-money.
The Option Adjusted cap and floor method utilizes the forward rate curve to predict the expected value of the index rate for each month of the loan. Based on this curve and the volatility associated with the curve at the appropriate forward period, the probability weighted impact of the cap and floor is calculated. The total impact of the cap or floor is the sum of monthly impacts over the contractual life of the opportunity.
Option Adjusted method uses a truncated normal distribution (truncated at 0% rate) with an absolute volatility to predict the likelihood of the cap or floor being in-the-money and thus the probability weighted impact. These calculations are impacted by both volatility and interpolation method as described below.
The Black 76 method is based on the Black model and is a variant of the Black-Scholes option pricing model. Similar to the Option Adjusted method, the Black 76 method uses the forward rate curve of the index combined with the index volatility to calculate the probability weighted impact of the cap or floor.
Unlike the Option Adjusted method, the Black 76 model is based on a log-normal distribution of the future rate with a relative volatility. Because of the log-normal nature of the distribution, there is no truncation associated with the Black 76 model, rather the distribution compresses as the forward rate approaches zero. As a result, and supported by the pricing data available, this method can more accurately assess the financial impact of the cap and floor in very low rate environments provided the volatility is appropriately set.
As with Option Adjusted, the volatility and interpolation methods are treated as described below.
2. Setting Maximum Cap Duration (Optional)
PrecisionLender recommends setting a maximum cap duration not past 5 years. Please talk to your treasury about the furthest forward acceptable cap.
3. Setting Up Volatility Method
You have the option of defining an absolute volatility, a relative volatility or both for any given duration. The more granular the volatility entered, the more sensitive the results will be to duration. The volatility applied to a given month (duration) is the entered value for the current or next highest duration on the entered volatility curve. For example, if volatility numbers are entered for 12, 24, and 36 month forward durations, the 12th month of the loan will calculate using the 12 month value, while the 13th month will calculate using the 24 month volatility amount. While the forward rate is interpolated, the volatility is not.
Additionally, if both the relative and absolute volatilities are entered the values will be summed. This allows you to enter a scalar and relative component to the volatility, and provides flexibility when structuring the volatility curve.
4. Setting the Interpolation Method
The Interpolation Method is set under the 'Funding Package Assumptions' at the Funding Package Level.
Select the Funding Package in which you wish to set the Interpolation Method. Once you're on the Funding Package screen, click 'Edit' in the upper left corner of the screen.
Because both the Option Adjusted and Black 76 cap and floor methods use a monthly value for the forward rate throughout the opportunity contractual life, months where the forward rate is not explicitly stated are interpolated. Please see the support article on Interpolation Methods for a better understanding of the interpolation options. For both the Option Adjusted and the Black 76 methods, it is suggested that the monotone convex interpolation be used.
Once your Interpolation Method settings have be configured, remember to click 'Save' in the upper left of the screen.