Accounting for Investments, Volume 2: Fixed Income Securities and Interest Rate Derivatives—A Practitioner's Guide

INTEREST RATE CAPS—DESCRIPTION OF THE PRODUCT

An interest rate cap is a form of interest rate derivative. It is also an over-the-counter interest rate derivative instrument. An interest rate cap is an interest rate management tool for an entity wanting to cap the interest commitment on its debt. It serves as a protection against increases in interest rates by limiting the maximum interest rate payable on its debt. This maximum interest rate is known as the cap rate or strike rate. In exchange for the protection of the cap instrument, the entity pays a premium. This is paid as a one-off up-front premium. If the reference interest rate rises above the cap rate then to that extent the seller of the contract would compensate the buyer. For example, if the strike rate of a cap contract is, say, 3 percent on a notional amount of say US$10 million, then if the interest rate shoots up to, say, 3.52 percent on the rate reset date, then the buyer of the cap would be compensated by the seller of the cap to the extent of the difference between the reference interest rate and the strike rate for the period starting from the rate reset date to the next interest payment date.

Interest rate cap—to pay

Interest rate caps are of two types—the first type being “to pay.” This means that for receiving an agreed premium, the buyer of this type of instrument agrees to compensate the seller of the instrument on the pay date any interest over and above the cap rate, if the benchmark interest rate is above ...