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

    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.
  3. Small Business

    Capitalization Rate

    Capitalization Rate is a financial term most commonly used in the real estate investment industry. It is often simply called the Cap Rate.
  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

    1Q Small Cap Earnings Preview: The Tide Has Turned

    Earnings growth for small caps should trail large caps badly in the first quarter.
  6. Investing

    Small Cap Vs. Mid Cap Vs. Large Cap Stocks in 2016

    Find out what to expect from small-, mid- and large-cap stocks in 2016, learn and why markets might not perform much better than 2015.
  7. 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.
  8. Investing

    Market Cap

    Learn more about how market cap represents the "price tag" of a company.
  9. Investing

    What's a Small Cap Stock?

    The “cap” in small cap stocks refers to a company’s capitalization as determined by the total market value of its publicly traded shares. Small cap stocks are generally defined as the stock of ...
  10. Insights

    Understanding Small- And Big-Cap Stocks

    If you don't realize how big small-cap stocks can be, you'll miss some good investment opportunities.
Frequently Asked Questions
  1. I want to invest my emergency fund to earn interest. What is a relatively safe and liquid investment I can easily withdraw from if disaster struck?

    Be sure you put your emergency money where you'll be able to access it quickly, easily and without penalty.
  2. What is arbitrage?

    Arbitrage is basically buying a security in one market and simultaneously selling it in another market at a higher price, ...
  3. What is the difference between upstream and downstream oil and gas operations?

    The closer to the end user a function or firm is, the further downstream it is said to be. Raw material extraction or production ...
  4. What is the difference between a capital expenditure and a revenue expenditure?

    Capital expenditures represent major investments of capital that a company makes to expand its business and generate additional ...
Trading Center