Interest rate cap

An interest rate cap is a type of interest rate derivative in which the buyer receives payments at the end of each period in which the interest rate exceeds the agreed strike price. An example of a cap would be an agreement to receive a payment for each month the LIBOR rate exceeds 2.5%.

Similarly an interest rate floor is a derivative contract in which the buyer receives payments at the end of each period in which the interest rate is below the agreed strike price.

Caps and floors can be used to hedge against interest rate fluctuations. For example, a borrower who is paying the LIBOR rate on a loan can protect himself against a rise in rates by buying a cap at 2.5%. If the interest rate exceeds 2.5% in a given period the payment received from the derivative can be used to help make the interest payment for that period, thus the interest payments are effectively "capped" at 2.5% from the borrowers' point of view.

An interest rate cap is a derivative in which the buyer receives payments at the end of each period in which the interest rate exceeds the agreed strike price. An example of a cap would be an agreement to receive a payment for each month the LIBOR rate exceeds 2.5%. They are most frequently taken out for periods of between 2 and 5 years, although this can vary considerably. Since the strike price reflects the maximum interest rate payable by the purchaser of the cap, it is frequently a whole number integer, for example 5% or 7%. By comparison the underlying index for a cap is frequently a LIBOR rate, or a national interest rate. The extent of the cap is known as its notional profile and can change over the lifetime of a cap, for example, to reflect amounts borrowed under an amortizing loan. The purchase price of a cap is a one-off cost and is known as the premium.

The purchaser of a cap will continue to benefit from any fall in interest rates below the strike price, which makes the cap a popular means of hedging a floating rate loan.

The interest rate cap can be analyzed as a series of European call options, known as caplets, which exist for each period the cap agreement is in existence. Unlike other types of option, it is generally not necessary for the purchaser of a cap to notify the seller in order to exercise it, as this will happen automatically if the interest rate exceeds the strike price. Each caplet is settled in cash at the end of the period to which it relates.

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Wikipedia