Interest Rate Caps protect the holders from generating loss due to interest rate rise, by making payment in every period. The payments are made in only that period when the underlying interest rate or index interest rate exceeds the cap rate. Paying Premium can purchase these Interest Rate Caps.
By Cap, here we actually mean Interest Rate Cap. Interest Rate Cap is an Over the Counter (OTC) derivative, which protects the holders from generating loss. When the short-term interest rates rise, the Interest Rate Cap protects the holders by making a payment to the holders. Whenever the underlying interest rate exceeds the strike rate, the holders get paid through the Interest Rate Cap.
It should be mentioned that, here by underlying interest rate we mean the reference interest rate or index interest rate and by strike rate we mean the cap rate. For getting the benefit of Interest Rate Cap, the holders are required to purchase the Caps by paying Premium.
These Interest Rate Caps generally hold expiration period of 1 year to 7 years. The holders get payments from the Interest Rate Caps on a semi-annual or quarterly or monthly basis.The period of the Interest Rate Caps are generally determined by the maturity of reference interest rate or index interest rate.
In every period, Interest Rate Caps make payment to the holders after comparing the present level of reference interest rate with the Cap Rate. The amount of payment is determined by the difference between the cap rate and index interest rate, the notional amount of the contract and the length of the particular period.
The persons who issue floating rate debt mostly purchase the Interest Rate Caps. By the rise in interest rate, the financing costs of these issuers go up. So, in order to prevent themselves from loss, the issuers of floating rate debt buy Interest Rate Caps.
It can be mentioned here that, an Interest Rate Cap can be considered as a series of Caplets. The value of these Caplets or Interest Rate Options determines the price of Interest Rate Caps.
Last Updated on : 1st August 2013