A five-year cap is reset annually period. The cap rate is 3% and the notional principal is $100 million. The 12-month LIBOR interest rate for the third year proves to be 5%. Which of the following is approximately true?
A) The resulting payoff is $2 million at the beginning of the third year
B) The resulting payoff is $2 million at the end of the fifth year
C) The resulting payoff is $2 million at the end of the third year
D) The resulting payoff is $2 million half way through the third year

Question

Quizplus · Accepted Answer

The five-year cap is reset annually, so the cap rate of 3% applies each year. The LIBOR rate for the third year is 5%, which is above the cap rate. Therefore, the cap will be applied, and the interest rate payable will be capped at 3%. This means that the amount of interest payable is 3% x $100 million = $3 million per year. The payoff would be the difference between the capped interest rate of $3 million and the actual interest payable at the LIBOR rate of 5%, which is $2 million ($3 million - $1 million).

Since the cap rate resets annually, the resulting payoff of $2 million at the end of the third year is correct as the cap would be re-evaluated and reset at the start of the next year. The payoff is not at the beginning of the third year, halfway through the third year, or at the end of the fifth year, as these options do not take into account the annual resetting of the cap rate.

A Five-Year Cap Is Reset Annually Period