Interest Rate Cap
An interest rate cap is an agreement between two parties providing the purchaser an interest rate ceiling or ‘cap’ on interest payments on floating rate debts. The rate cap itself provides a periodic payment based upon the positive amount by which the reference index rate (e.g. 3m LIBOR) exceeds the strike rate. This financial instrument is primarily used by issuers of floating rate debts in situations where short term interest rates are expected to increase. Rate caps can be viewed as insurance, ensuring that the maximum borrowing rate never exceeds the specified cap level. In exchange for this peace of mind, the purchaser pays the financial institution a premium.
Under a usual transaction, the purchaser of the cap, in return for an up-front fee or premium, is protected against rises in interest rates on its floating rate borrowings beyond a certain nominated upper limit. If market rates exceed the ceiling or cap rate, then the provider of the cap will make payments to the buyer sufficient enough to bring its rate back to the ceiling level. When rates are below the ceiling, no payments are made and the borrower pays market rates. The buyer of the cap therefore enjoys a fixed rate when market rates are above the cap and a floating rate when interest rates are below the cap.