Can somebody explain Cap risk in Fixed income?
Straight floating-rate bonds reset to par at every coupon date (assuming that the coupon is the market rate, not the market rate plus a spread).
A capped floating-rate bond may reset to lower than par if market rates exceed the cap rate. That’s the risk.
Can you please dig more deep into risk part…Why market rate exceeeds cap is a risk and what happens if market rate goes below cap rate?
You own a floating-rate bond with a par value of €1,000 and a market price of €1,000, no matter what.
If you need to sell it, you’ll get €1,000.
But if it has a cap, then the market price can drop below €1,000, and if you need to sell it you’ll get less than €1,000.
That’s the risk: the market price is uncertain, and it could drop below par.
If the market rate is below the cap, it will pay a coupon equal to the market rate: price is €1,000.
I really appreciate it !
My pleasure.