What is an interest rate cap?
An interest rate cap is a type of interest rate derivative in which the seller agrees to pay the buyer interests if a reference rate is above a pre-determined fixed rate (strike price). The reference rate is usually an index, such as the LIBOR, and the contract will specify how often interest payments are made. Interest rate caps are used both for hedging and speculation.
For example, let’s say that you think that interest rates are going to rise. You could buy an interest rate cap to protect yourself from having to pay higher interest payments on your variable-rate debt. Alternatively, you could sell an interest rate cap if you think that interest rates are going to stay relatively flat.
Cambridge
an agreement in which a financial organization puts an upper (= the cap) and a lower (= the collar) limit on an interest rate for a loan, a share price, etc.
Wikipedia
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%.
What are interest rate caps used for?
Caps are used to protect against rising interest rates and are often used in conjunction with other derivatives such as swaps and floors. They can be used by hedgers to lock in a maximum interest rate on a loan, or by speculators betting on falling rates.
The most common type of interest rate cap is the three-month London Interbank Offered Rate (LIBOR) cap, which is used to protect against rising borrowing costs. Other popular types of interest rate caps include the one-year LIBOR cap and the six-month EURIBOR (European Interbank Offered Rate) cap.
