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Tutorial: Interest Cap Warrants

What is an interest cap warrant?

For a one-time payment at the start of the term interest cap warrants limit the reference interest rate on which the loan is based. A EUR interest cap warrant guarantees the right to receive quarterly compensation if the underlying EURIBOR has exceeded a certain strike.
The interest cap warrant is a suitable tool if you want to limit your interest rate risk for your loan. Especially if you want to benefit from low interest rates and you can not assess the further interest rate development, the interest cap warrant offers a protection in this regard.

We distinguish:
* bullet interest cap warrants: the protected volume remains the same until maturity of the interest cap warrant.
* obliterative interest cap warrants: the protected volume by the interest cap warrant is linearly reduced to zero at maturity.
* part-obliterative interest cap warrants: the protected volume by the interest cap warrant is linearly reduced to a certain amount at maturity, as shown in the redemption plan.
* forward start interest cap warrants: the protection starts at a later date in the future.

How does the interest cap warrant work?

Assuming you have a loan which is linked to the 3-month EURIBOR. On the one hand, you want to benefit from the low interest rates (i.e. not agree on a fixed interest rate for the loan) and on the other you want to be protected against rising interest rates.

Let's take a look at the loan in detail:
3-month Euribor: 0.25% p. a.
+ customer margin: 1.75% p. a.
Interest rate of the loan: 2.00% p. a.

Imagine buying an interest cap warrant with a strike (= cap) of 2.50% p. a. The 3-month EURIBOR rises to 4.00% over the next few years. Then you receive a quarterly payout starting at a market interest rate of 2.50%. The payout is the positive amount from the current 3-month EURIBOR at the reporting date minus the strike (in our example 2.50%). Please note that the customer margin is not included.

Your benefits

TThe interest cap warrant is a suitable instrument, if you do not have a sound opinion on the future interest development and want to limit your interest rate risk, while at the same time you want to benefit from low interest rates.

Your advantages

  • Protection against rising interest rates for new and existing EUR loans.
  • The strike can be set individually.
  • Holders of a loan can continue to benefit from low interest rates compared to a fixed rate loan.
  • The maximum interest payment and thus the highest possible loan installment gets easier to calculate.
  • Quarterly compensation payments when the EURIBOR is above the strike.
  • Interest cap warrants are available with different maturities.

Risks you should be aware of

  • There is no payout, if the 3-month EURIBOR is below the strike.
  • Interest cannot be fully hedged as the interest rate fixing dates of the loan and the interest cap warrant may differ.
  • The interest cap warrant repays in capital rates, the loan usually in flat rates.
  • The amount of the loan may differ from the amount of the warrant.
  • Upon purchase of the interest cap warrant, a one-time premium is paid, which is lost at the latest at maturity.
  • Investors bear the risk of the issuer (Erste Group Bank AG).
  • Interest cap warrants are not covered by any deposit guarantee scheme. Investors are exposed to the risk that Erste Group Bank AG may not be able to meet its obligations arising from the warrant in the event of insolvency or over-indebtedness or from an official order (bail-in regime). A total loss of invested capital is possible.

How does the interest cap warrant react to…

… rising interest rates?
If interest rates increase, the value of the warrant increases, as the probability of compensation payments rise, respectively the probability of a higher compensation payment increases.

… stable interest rates?
In a stable market environment, the cap will slowly lose value due to the decreasing time value of the option.

… falling interest rates?
If the interest level decreases, the value of the cap decreases, as the probability of compensation is decreasing.


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