3.2.4.10 The basics and Australian specific commentary

Set out below are the following:

  • "What are interest rate caps, collars and floors?";
  • "Preliminary issues";
  • "What is the May 1989 Addendum and is it relevant?"; and
  • "What is Australian Addendum No. 1 - Interest Rate Caps, Collars and Floors?"

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What are interest rate caps, collars and floors

An interest rate cap is a transaction in which one party pays a single or periodic fixed amount and the other party pays periodic amounts of the same currency based on the excess, if any, of a specified floating rate that is reset periodically over a specified per annum rate.

An interest rate floor is a transaction in which one party pays a single or periodic fixed amount and the other party pays periodic amounts of the same currency based on the excess, if any, of a specified per annum rate over a specified floating rate.

An interest rate collar is a combination of a cap and a floor where one party is the floating rate payer on the cap and the other party is the floating rate payer on the floor.

** This part of the Guide deals only with interest rate caps, collars and floors **

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Preliminary issues

To document interest rate caps, collars and floors under Australian law using the ISDA Master Agreement participants should ensure that they have executed an ISDA Master Agreement with their counterparty. 

Has the participant used ISDA documents before? If a participant is not familiar with the ISDA documents, it is recommended that they:

  • read the User's Guide and the ISDA Master Agreement;
  • read the 2.1 "ISDA" commentary set out in the Guide; 
  • read this part of the Guide, "Interest rate caps, collars and floors".

If a participant is familiar with the ISDA documents, it is recommended that they start by reading this part and refer to the other portions of the Guide as necessary.

Unless otherwise stated, this commentary on interest rate caps, collars and floors is prepared on the assumption that participants use the 2006 Definitions and the 2002 ISDA Master Agreement.

A number of important changes were made to the hard-copy version of the Guide on 1 January 2002. Updates 1 to 8 in 6.1.2 "Updates as at June 30 2007" which can be found in 6 "History", explain these changes. It is recommended that participants carefully read these items. Take particular care in relation to the comments at the February 2005 Update to Part 5 in 6.1.2 "Updates as at June 30 2007" (ISDA Definitions booklets). 

The issues discussed in 4 "Issues", such as regulation, tax/stamp duty, netting, investment managers, novation and collateral, may also be relevant to interest rate cap, collar and floor transactions.

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What is the May 1989 Addendum and is it relevant?

The May 1989 Addendum is an addendum issued by ISDA in May 1989 to assist in documenting interest rate caps, collars and floors. For documenting interest rate caps, collars and floors under Australian law participants need not consider it because AFMA has prepared an Australian Addendum for interest rate caps, collars and floors. But it is helpful to understand what is in the May 1989 Addendum.  It contains 4 paragraphs.

  • Commentary on paragraph (1) of the May 1989 Addendum. If the ISDA Master Agreement incorporates the 2006 Definitions, then participants need not incorporate paragraphs (1) and (2) of the May 1989 Addendum into the relevant ISDA Master Agreement. This is because the definition of Floating Rate in the 2006 Definitions incorporates the material in paragraph (2) of the May 1989 Addendum and is drafted so that it is no longer necessary to define "Rate Protection Transaction". It is then not necessary to specify in the Confirmation that the transaction is a "Rate Protection Transaction".
  • Commentary on paragraph (2) of the May 1989 Addendum. As noted above, paragraph (2) of the May 1989 Addendum need not be incorporated in participants' ISDA Master Agreements. This is because the 2006 Definitions incorporate the provisions of paragraph (2) of the May 1989 Addendum. The following commentary explains how these provisions work.

    In a cap or floor transaction, the Fixed Rate Payer is the purchaser of the cap or floor, the Floating Rate Payer is the seller and the Fixed Amount represents the option fee or premium.
  • Floating Rate - Rate cap or rate floor transactions. The Floating Rate is calculated as follows:
    • determine a "Floating Rate" in accordance with the definition of "Floating Rate" in the 2006 Definitions. For example: If the Floating Rate Option specifies "AUD-BBR-BBSW", determine the relevant "BBSW" on the applicable Reset Date; then
    • for a cap, deduct from this the Cap Rate specified in the Confirmation; or
    • for a floor, deduct this from the Floor Rate specified in the Confirmation.
  • The balance is the Floating Rate.

    Section 6.1 of the 2006 Definitions provides for calculation of the Floating Amount on the Swap Basis. This Guide includes a formula in 2.1.4.60.3 "FRA Yield Discounting - Recommended Clause" that can be inserted in a Schedule to an ISDA Master Agreement to be used for calculating the Floating Amount in advance.

    Floating Rate - Rate collar transactions. In a Rate Collar Transaction, there are two Floating Rate Payers and the Confirmation provides details to allow calculation of two Floating Amounts. One of the Floating Amounts is calculated using a Floating Rate which is a market rate less the Cap Rate. The other Floating Amount is calculated using a Floating Rate which is the Floor Rate minus a market rate.

    Fixed Amounts. The purchaser of a cap or floor is designated as the Fixed Rate Payer and must pay an option fee or premium. There are various ways in which the fee or premium might be payable. One method used is payment by instalments. Another is by way of a single lump sum. If the lump sum method is agreed, the Australian market convention is for the premium to be payable within two Business Days of the Trade Date.


    If the lump sum method is agreed, then once the Fixed Amount has been paid, the Fixed Rate Payer has no future payment obligations.  This contrasts with the position in a swap transaction where both parties usually have contingent payment obligations throughout the term of the transaction.
  • Commentary on paragraph (3) of the May 1989 Addendum. Paragraph (3) was intended to clarify the application of the definition of Market Quotation to fully paid caps and floors. This is now redundant in view of the definition of Close-out Amount in the 2002 ISDA Master Agreements.
  • Commentary on paragraph 4 of the May 1989 Addendum. Paragraph (4) limits the right of the Seller to terminate interest rate caps, collars and floors. The argument is that, if the Buyer is fully paid and therefore the Seller has no credit exposure, the right of the Seller to terminate should be limited to when the occurrence imposes some hardship on the Seller. (There is further commentary on paragraph (4) in the May 1989 Commentary).  Paragraph (4) is not incorporated in the 2006 Definitions.

    AFMA recommends that it is preferable to give the Seller the right to terminate all interest rate caps, collars and floors. This is because it will probably be desirable for the Seller to terminate all Transactions with the Buyer immediately following an Event of Default. There is no adverse effect on the Buyer because it receives full value from the Seller for the Terminated Transactions.

    **Accordingly, it is recommended that participants not include paragraph (4) of the May 1989 Addendum in their ISDA Master Agreement **

    However, when this approach is followed, it is recommended that an additional clause relating to conditions precedent be included in the Master Agreement. See 2.1.4.70.9 "Amended Condition Precedent or Additional Termination Event". 
  • Commentary on the Optional Paragraph included in the May 1989 Commentary.  In addition to the four paragraphs included in the May 1989 Addendum there is an Optional Paragraph which is set out in the May 1989 Commentary. The May 1989 Commentary explains the competing arguments for including or omitting this clause. As the 2002 ISDA Master Agreement provides for full two way payments in all circumstances following termination, then the Optional Paragraph may be ignored. 

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What is Australian Addendum No. 1 - Interest Rate Caps, Collars and Floors?

Until 1 January 2002 AFMA recommended using Australian Addendum No. 1 - Interest Rate Caps, Collars and Floors. This is no longer recommended. The reasons for this together with a copy of the Addendum and commentary on it are in the 6.2 "History" (see pre-February 2005 version of the Guide). See also Update 1 in 6.1.2 "Updates as at June 30 2007".


Last Update Date 29 Jun 2011