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. European Option

    An option that can only be exercised at the end of its life, ...
  4. Interest Rate Ceiling

    The maximum interest rate that a financial institution can charge ...
  5. Call Option

    An agreement that gives an investor the right (but not the obligation) ...
  6. In The Money

    1. For a call option, when the option's strike price is below ...
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. What options strategies are best suited for investing in the aerospace sector?

    The best options strategies for investing in the aerospace sector exploit the sector's volatility and propensity for big ... Read Full Answer >>
  3. What options strategies are best suited for investing in the Internet sector?

    The long straddle and long strangle options strategies enable investors to capitalize on the Internet sector's volatility. ... Read Full Answer >>
  4. Where can I buy covered call ETFs (exchange-traded funds)?

    Covered calls can be traded through any major retail broker. Investors need to have their brokerage accounts approved for ... Read Full Answer >>
  5. How do I set a strike price in a put?

    The strike price of a put option is the price at which the option can be exercised. A put option gives the buyer, or holder, ... Read Full Answer >>
  6. Is there a better metric for hedging options than delta?

    Delta hedging is a way traders mitigate risk in their positions by taking an offsetting position. Although it is a common ... 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. Trading Strategies

    A Guide Of Option Trading Strategies For Beginners

    Options offer alternative strategies for investors to profit from trading underlying securities, provided the beginner understands the pros and cons.

You May Also Like

Hot Definitions
  1. Fixed-Income Arbitrage

    An investment strategy that attempts to profit from arbitrage opportunities in interest rate securities. When using a fixed-income ...
  2. Venture-Capital-Backed IPO

    The selling to the public of shares in a company that has previously been funded primarily by private investors. The alternative ...
  3. Merger Arbitrage

    A hedge fund strategy in which the stocks of two merging companies are simultaneously bought and sold to create a riskless ...
  4. Market Failure

    An economic term that encompasses a situation where, in any given market, the quantity of a product demanded by consumers ...
  5. Unsystematic Risk

    Company or industry specific risk that is inherent in each investment. The amount of unsystematic risk can be reduced through ...
  6. Security Market Line - SML

    A line that graphs the systematic, or market, risk versus return of the whole market at a certain time and shows all risky ...
Trading Center