Forex Investment and Currency Trading

Description

An Autocap is a variation of the vanilla Interest Rate Cap. An Autocap will be cheaper than a vanilla Cap. However, unlike the vanilla Cap, the Autocap does not have “caplets” for every fixing date. For a three year structure with quarterly fixings, a vanilla Cap would include 12 caplets (technically 11 if it is spot start), one for each period; in the Autocap, the company can choose the number of caplets, typically, say, 6 caplets out of 12 periods (an Autocap with 12 caplets would be the same as a vanilla Cap!).

Autocaps are predominantly used for liability management and therefore purchased by companies. In an Autocap, the first caplets which are in the money would automatically be exercised. Once all the purchased caplets have been exercised, the company would no longer enjoy interest rate protection for the remaining tenor of the transaction. Of course, at the end of the Autocap tenor any unexercised caplets will expire.

Application

As with a vanilla Cap, an Autocap is a useful tool for hedging interest rate risks whilst reducing upfront premium and retaining some upside exposure. Autocaps are cost effective and particularly useful when the company has a view on future interest rate movements.

In this example, the company wishes to hedge against a rise in 3 month USD LIBOR rates. However the company believes that the probability is that future LIBOR rates will fall. Combining its view with a hedge, the company buys a 6/12 Autocap. This costs 30bp, compared to 62bp for a 5.30% vanilla Cap.

• If the company’s view on rates is correct, they will save the 32bp difference in premium between a Cap and AutoCap.
• If 3 month LIBOR stays above the strike for longer than expected, the company will be unhedged after the 6th cap has been exercised.
• Autocaps become relatively more expensive when volatilities are high and when the yield curve “inversion” risk is greater. They become less expensive when the strike is closer to the Swap rate, as the initial caplets are more likely to be exercised (and the longer dated and riskier caplets are less likely to be exercised).

Variations

• The simplest variation is to change the number of exercisable caplets, “N”. The higher the N, the closer the premium is to that of the vanilla Cap.
• Autocaps can be varied in a similar way to Caps, including in-arrears fixing, mismatched rate tenors, Quantos and non-bullet notionals.