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. Managing Wealth

    Managing Interest Rate Risk

    Learn which tools you need to manage the risk that comes with changing rates.
  2. 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.
  3. Investing

    An Introduction To Small Cap Stocks

    When it comes to a company's size, bigger isn't always better for investors. Find out more here.
  4. Investing

    Market Capitalization Defined

    Find out the differences between mega-, large-, mid- and small-cap stocks and how each suits different investing styles.
  5. 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.
  6. Insights

    How Interest Rates Affect The U.S. Markets

    Interest rates can have both positive and negative effects on U.S. stocks, bonds and inflation.
  7. 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?
  8. 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.
  9. Investing

    Why You Need to Watch Small Caps (IWM)

    Small cap performance impacts broad market tone and direction while revealing important details about market psychology.
  10. Investing

    Interest Rates Explained: Nominal, Real, Effective

    Interest rates are divided into subcategories. Smart investors look beyond the nominal or coupon rate of a bond or loan to see if it fits their objectives.
Frequently Asked Questions
  1. What are Common Examples of Monopolistic Markets?

    Discover what causes real instances of market monopoly, how it persists and where monopoly privilege is most common in the ...
  2. What is the gold standard?

    The gold standard is a monetary system where a country's currency or paper money has a value directly linked to gold, but ...
  3. What's the most expensive stock of all time?

    The most expensive publicly traded stock of all time is Warren Buffett’s Berkshire Hathaway.
  4. What is a "socially responsible" mutual fund?

    As the name suggests, socially responsible mutual funds invest exclusively in socially responsible investments.
Trading Center