Interest Rate Cap
An interest rate cap is actually a series of European interest call options (called caplets), with a particular interest rate, each of which expire on the date the floating loan rate will be reset. At each interest payment date the holder decides whether to exercise or let that particular option expire. In an interest rate cap, the seller agrees to compensate the buyer for the amount by which an underlying short-term rate exceeds a specified rate on a series of dates during the life of the contract. Interest rate caps are used often by borrowers in order to hedge against floating rate risk.
 

Formula 15.5
(Current market rate - Cap Rate) x principal x (# days to maturity/360)

Interest Rate Floor
Floors are similar to caps in that they consist of a series of European interest put options (called caplets) with a particular interest rate, each of which expire on the date the floating loan rate will be reset. In an interest rate floor, the seller agrees to compensate the buyer for a rate falling below the specified rate during the contract period. A collar is a combination of a long (short) cap and short (long) floor, struck at different rates. The difference occurs in that on each date the writer pays the holder if the reference rate drops below the floor. Lenders often use this method to hedge against falling interest rates.

The cash paid to the holder is as follows:
 

Formula 15.6
(Floor rate - Current market rate) x principal x (# days to maturity/360)

 



Minimum and Maximum Values for Options

Related Articles
  1. Trading

    Managing Interest Rate Risk

    Interest rate risk stems from the possibility that an interest-bearing asset’s value will change due to changing interest rates.
  2. Investing

    Market Capitalization Defined

    Find out the differences between mega-, large-, mid- and small-cap stocks and how each suits different investing styles.
  3. Investing

    Forces Behind Interest Rates

    Interest is a cost for one party, and income for another. Regardless of the perspective, interest rates are always changing.
  4. Managing Wealth

    Dissecting the Simple Interest Formula

    Simple interest ignores the effect of compounding: it's only calculated on the principal amount. This makes it easier to calculate than compound interest.
  5. Investing

    How Negative Interest Rates Can Affect Banks' Bottom Lines

    Examine the impacts of low interest rates on banking industry profits and find out if negative interest rates will have a more extreme effect.
  6. Insights

    Forces Behind Interest Rates

    Get a deeper understanding of the importance of interest rates and what makes them change.
  7. Investing

    Calculating Future Value

    Future value is the value of an asset or cash at a specified date in the future that is equivalent in value to a specified sum today.
  8. Investing

    Market Cap Valuations For 2010

    How do the P/E ratios for the major market caps stack up against one another, and against themselves, for 2010?
  9. Personal Finance

    Got a Good Mortgage Rate? Lock It Up!

    Rising rates mean rising profits for lenders, providing incentive to increase rates whenever possible.
  10. Insights

    When Will Interest Rates Rise?

    Find out if -- and why -- the Federal Reserve will keep raising interest rates and what that might mean for savers, investors and the entire economy.
Frequently Asked Questions
  1. Depreciation Can Shield Taxes, Bolster Cash Flow

    Depreciation can be used as a tax-deductible expense to reduce tax costs, bolstering cash flow
  2. What schools did Warren Buffett attend on his way to getting his science and economics degrees?

    Learn how Warren Buffett became so successful through his attendance at multiple prestigious schools and his real-world experiences.
  3. How many attempts at each CFA exam is a candidate permitted?

    The CFA Institute allows an individual an unlimited amount of attempts at each examination.Although you can attempt the examination ...
  4. What's the average salary of a market research analyst?

    Learn about average stock market analyst salaries in the U.S. and different factors that affect salaries and overall levels ...
Trading Center