Caplet

AAA

DEFINITION of 'Caplet'

A European interest call option that sets a maximum future interest rate for an interest rate derivative. A caplet is analyzed as a call option, with the duration of the option typically set to coincide with interest rate payment dates. A series of caplets is called a cap, and holders typically purchase a cap to cover back-to-back time periods.  

INVESTOPEDIA EXPLAINS 'Caplet'

Caplets are used by investors to hedge against the risk associated with floating interest rate financial products, though investors are more likely to invest in a cap rather than single caplets. Caplet holders must decide whether to exercise the option or let it expire when each interest rate payment day is met. If the rate locked in by the caplet is greater than the strike rate at expiry, then the option pays the difference of the two rates multiplied by a factor. A caplet that is purchased before an increase in market yield will be in-the-money upon expiry, and a caplet that is sold will be in-the-money if the market yield declines.

Returns on a caplet are calculated as:

 (interest rate – caplet rate) x principal x (# of days to maturity/360)

For example, take an investor who has purchased a 2-year cap that references the 3-month LIBOR rate. This investment is composed of seven caplets, and each caplet lasts three months. The price of the cap is the sum of the price of each of the seven caplets. 

RELATED TERMS
  1. Interest Rate Future

    A futures contract with an underlying instrument that pays interest. ...
  2. Periodic Interest Rate Cap

    A part of an interest rate cap structure on loans and mortgages. ...
  3. Floating Interest Rate

    An interest rate that is allowed to move up and down with the ...
  4. Interest Rate Call Option

    An interest rate derivative in which the holder has the right ...
  5. Call Option

    An agreement that gives an investor the right (but not the obligation) ...
  6. Interest Rate Cap Structure

    Limits to the interest rate on an adjustable-rate loan - frequently ...
RELATED FAQS
  1. Can an option be exercised on the expiration date?

    The use of options has increased dramatically over the years as a way to profit from or hedge against the volatile movements ... Read Full Answer >>
  2. How can I use an out-of-the-money put time spread for downside risk?

    Long Put Calendar Spread An out-of-the-money put time spread can hedge downside risk by selling an out-of-the-money put ... Read Full Answer >>
  3. Can an investor buy leveraged ETFs that track the automotive sector?

    As of 2015, no leveraged exchange-traded funds, or ETFs, track the automotive sector. However, a non-leveraged ETF tracks ... Read Full Answer >>
  4. What risks should I consider taking a short put position?

    The risks to consider before taking a short put position are the odds of sustained weakness in the asset price and a spike ... Read Full Answer >>
  5. Why should I consider buying an option if it's out-of-the-money?

    One situation when a trader may want to buy an out-of-the-money option is to hedge a stock position. A trader may want to ... Read Full Answer >>
  6. How do traders use out-of-the-money options to hedge?

    Traders can utilize out-of-the-money options to hedge an existing market position by either buying or selling options. A ... Read Full Answer >>
Related Articles
  1. Options & Futures

    Reducing Risk With Options

    If you want to use leverage to your advantage, you must know how many contracts to buy.
  2. Options & Futures

    American Vs. European Options

    These two options have many similar characteristics, but it's the differences that are important.
  3. Options & Futures

    Managing Interest Rate Risk

    Learn which tools you need to manage the risk that comes with changing rates.
  4. Economics

    Forces Behind Interest Rates

    Get a deeper understanding of the importance of interest rates and what makes them change.
  5. Options & Futures

    Exploring European Options

    The ability to exercise only on the expiration date is what sets these options apart.
  6. Options & Futures

    Forget The Stop, You've Got Options

    Using options instead of stop-loss orders adds finesse and control in limiting losses.
  7. Options & Futures

    Dividends, Interest Rates And Their Effect On Stock Options

    Learn how analyzing these variables are crucial to knowing when to exercise early.
  8. Markets

    Hedging With Puts And Calls

    This trading strategy can reduce your risk - but only if you use it effectively.
  9. Options & Futures

    The Ins And Outs Of Selling Options

    Selling options can seem intimidating but with these tips, you can enter the market with confidence.
  10. Investing

    Prospering In The Next Bear Market: Here's How

    Prepare to survive, and even prosper, in the impending bear market, by considering and putting into action the following four strategies.

You May Also Like

Hot Definitions
  1. Treasury Yield

    The return on investment, expressed as a percentage, on the debt obligations of the U.S. government. Treasuries are considered ...
  2. Bund

    A bond issued by Germany's federal government, or the German word for "bond." Bunds are the German equivalent of U.S. Treasury ...
  3. European Central Bank - ECB

    The central bank responsible for the monetary system of the European Union (EU) and the euro currency. The bank was formed ...
  4. Quantitative Easing

    An unconventional monetary policy in which a central bank purchases private sector financial assets in order to lower interest ...
  5. Current Account Deficit

    A measurement of a country’s trade in which the value of goods and services it imports exceeds the value of goods and services ...
  6. International Monetary Fund - IMF

    An international organization created for the purpose of: 1. Promoting global monetary and exchange stability. 2. Facilitating ...
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!