An interest rate cap is a derivative in which the buyer receives payments at the end of each period in which the interest rate exceeds the agreed strike price. An example of a cap would be an agreement to receive a payment for each month the LIBOR rate exceeds 2.5%.
The interest rate cap can be analyzed as a series of European call options or caplets which exist for each period the cap agreement is in existence.
In mathematical terms, a caplet payoff on a rate L struck at K is
where N is the notional value exchanged and is the day count fraction corresponding to the period to which L applies. For example suppose you own a caplet on the six month USD LIBOR rate with an expiry of 1 February 2007 struck at 2.5% with a notional of 1 million dollars. Then if the USD LIBOR rate sets at 3% on 1 February you receive
Customarily the payment is made at the end of the rate period, in this case on 1 August.
Read more about this topic: Interest Rate Cap And Floor
Famous quotes containing the words interest, rate and/or cap:
“There are persons who, when they cease to shock us, cease to interest us.”
—F.H. (Francis Herbert)
“We all run on two clocks. One is the outside clock, which ticks away our decades and brings us ceaselessly to the dry season. The other is the inside clock, where you are your own timekeeper and determine your own chronology, your own internal weather and your own rate of living. Sometimes the inner clock runs itself out long before the outer one, and you see a dead man going through the motions of living.”
—Max Lerner (b. 1902)
“‘I have cap and bells,’ he pondered,
‘I will send them to her and die’;
And when the morning whitened
He left them where she went by.”
—William Butler Yeats (1865–1939)