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 is a mortifying experience in particular, which does not fail to wreak itself also in the general history; I mean “the foolish face of praise,” the forced smile which we put on in company where we do not feel at ease, in answer to conversation which does not interest us. The muscles, not spontaneously moved but moved, by a low usurping wilfulness, grow tight about the outline of the face, with the most disagreeable sensation.”
—Ralph Waldo Emerson (1803–1882)
“Whoever thinks his friend more important than his country, I rate him nowhere.”
—Sophocles (497–406/5 B.C.)
“In time your relatives will come to accept the idea that a career is as important to you as your family. Of course, in time the polar ice cap will melt.”
—Barbara Dale (b. 1940)