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Why Are Cap Costs Rising?

February 26, 2021

With the recent rise in rates driven by the blue wave in Washington and the deployment of numerous Covid vaccine candidates, we’ve had many of our clients reach out with concerns over rising rate cap costs.  As we continue to see signs of economic recovery post-Covid, we expect to see cap costs continue to trend higher.

Although cap costs are driven by numerous factors, term will have one of the most significant impacts on pricing.  Generally, after the first couple years, each additional month added to the cap’s term will exponentially increase the cost.  In today’s rate environment, a 4+ year cap will cost substantially more than a 3 year cap, which will cost substantially more than a 1-2 year cap.

This will hold true even if markets are projecting the cap will never pay out.  The cause of this is variance.  The further out traders look, the less certain they are about the potential path of rates.  Although the market may not project rates to rise for the next three years, there’s greater confidence in year one’s projection than year three.

The graph below highlights cap values in basis points of the loan over the term of the hedge.  Almost all of the cap’s value is in the third year, with costs of that third year having trended higher over the past six months.

It’s important to remember that markets are forward looking.  So, while it’s true that the Fed has committed to keeping rates near zero through 2023, any talks of changes to Fed policy and continually positive economic data prints will cause a rise in rate expectations.  Markets will begin pricing in these changes well ahead of time, which will in turn impact hedging costs.

If you’re curious about what estimated pricing would be for your cap, check out our cap pricer.  Alternatively, reach out to the Pensford team at capteam@pensford.com or give us a call at (704) 887-9880 and we’d be happy to provide a quote.

Pensford