CAPS AND FLOORS
Caps are agreements between two parties, whereby one party for an up-front fee agrees to compensate the other if a designated interest rate (called the reference rate) exceeds a predetermined level. For a floor the payment is made if the reference rate is below a predetermined level. The party that benefits if the reference rate exceeds (in the case of a cap) or falls below (in the case of a floor) a predetermined level is called the buyer, and the party that must potentially make payments is called the seller. The predetermined interest rate level is called the strike rate. An interest rate cap specifies that the seller agrees to pay the buyer if the reference rate exceeds the strike rate. An interest rate floor specifies that the seller agrees to pay the buyer if the reference rate is below the strike rate.
The terms of an interest rate agreement include: (1) the reference rate; (2) the strike rate that sets the cap or floor; (3) the length of the agreement; (4) the frequency of reset; and (5) the notional amount (which determines the size of the payments). If a cap or a floor is in the money on the reset date, the payment by the seller is typically made in arrears.
A cap is essentially a strip of options. A borrower with an existing interest rate liability can protect against a rise in interest rates by purchasing a cap. If rates rise above the cap, the borrower will be compensated by the cap payout. Conversely, if rates fall the borrower gains from lower ...