A cap is an interest option. An option describes the right to buy or sell a given item at a later date and at an agreed price. A cap is a contractual agreement whereby upon payment of a premium the buyer is guaranteed a maximum interest rate. This means that the charge from an existing or future liability with a variable rate of interest will not exceed this set interest rate cap in the course of the term (interest rate hedge). The seller undertakes to compensate the buyer for any additional charge over and above the interest rate cap by making a payment to the buyer.
The opposite to a cap is a floor. With an interest rate floor, a contractual agreement is made for a minimum interest rate. This means that the income from an existing or future investment with variable interest for example may not fall below this set minimum interest rate. The buyer of an interest rate floor acquires a right from the seller to a compensation payment if a pre-defined reference rate of interest falls below a minimum level, also determined in advance, over the duration of the floor. To this end the buyer pays the seller a one-off premium when concluding the contract.
When entering into a cap or floor agreement the buyer and the seller agree on
- the term.
- the maximum interest rate for the cap or the minimum interest rate for the floor.
- the reference interest rate.
- the underlying nominal amount of capital.
A company has taken out a loan on the money market for 3 years. It wants to protect itself against rising interest rates on the money market, without foregoing the opportunity to benefit from falling money market rates. By buying an interest rate cap the company can set a maximum interest rate for the coming years in respect of the underlying liability.