Interest Rate Cap
AdvancedAn interest rate cap is a derivative contract that pays the holder when a floating interest rate rises above a set level, called the cap rate, protecting borrowers against rising interest costs.
A cap works like insurance on a floating-rate loan. The borrower pays an upfront premium. Then, at each payment date, if the reference rate is above the cap rate, the seller of the cap pays the difference on the notional amount for that period. If the rate stays below the cap, nothing is paid.
For example, a company with a 20,000,000 floating-rate loan buys a cap at 5%. If the reference rate rises to 6.5% for a quarter, the cap pays 1.5% on 20,000,000 for a quarter of a year, or 75,000, offsetting the extra interest.
A cap is made up of a series of individual options, called caplets, one for each interest period. Its price depends on the cap rate, the length of the cap, current rates and expected interest rate volatility.
Caps let borrowers benefit from low rates while limiting the cost if rates rise sharply. Lenders sometimes require borrowers with floating-rate debt, such as in property or leveraged buyouts, to buy caps. Combining a cap with a floor creates a collar, which reduces the cost.
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