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.  

BREAKING DOWN '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. 

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