SUMMARY

  • An interest rate cap is a form of interest rate derivative. It is also an over-the-counter interest rate derivative instrument.
  • An interest rate cap is an interest rate management tool for an entity wanting to cap the interest commitment on its debt. It serves as a protection against increases in interest rates by limiting the maximum interest rate payable on its debt.
  • This maximum interest rate is known as the cap rate or strike rate. In exchange for the protection of the cap instrument, the entity pays a premium. This is paid as a one-off, up-front premium. If the reference interest rate rises above the cap rate then to that extent the seller of the contract would compensate the buyer.
  • Interest rate caps are of two types—the first type being “to pay.” This means that for receiving an agreed premium, the buyer of this type of instrument agrees to compensate the seller of the instrument on the pay date any interest over and above the cap rate, if the benchmark interest rate is above the cap rate on the reset date.
  • The premium is computed like any other option premium based on some mathematical model that takes into account several factors including the strike rate (cap rate), the present benchmark interest rate, the historical volatility of interest rates, the time period of the contract, amongst other factors.
  • The second type of interest rate cap is known as “to receive.” This means that for paying an agreed premium, the seller of this type of instrument agrees to compensate ...

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