A popular interest rate option offered by financial institutions in the over-the-counter market is an interest rate cap. Interest rate caps can best be understood by first considering a floating-rate note where the interest rate is reset periodically equal to LIBOR. The time between resets is known as the tenor. Suppose the tenor is 3 months. The interest rate on the note for the first 3 months is the initial 3-month LIBOR rate; the interest rate for the next 3 months is set equal to the 3-month LIBOR rate prevailing in the market at the 3-month point; and so on.

An interest rate cap is designed to provide insurance against the rate of interest on the floating-rate note rising above a certain level. This level ...

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