An interest rate cap is a derivative instrument that enables the holder to obtain protection from a rise in interest rates. The instrument arranges for the holder to receive a payment when the interest rate reaches a certain level known as the cap rate or strike rate. This periodic payment is computed by reference to the interest rate at the end of each period specified under the cap, which might be one month, three months or six months. If the interest rate has risen above the cap rate, a payment is made to the holder on the basis of the difference between the two rates. This payment also takes into account the length of the specified period and the notional amount of the contract.
An interest rate cap can be used by a person who is taking out a floating rate loan. The holder of the cap might be looking for protection from the additional financing costs that would result from a rise in interest rates. Normally, the holder would pay a premium for the cap at the time of purchase. This premium may be priced using a formula that computes the price of the cap on the basis of the price of a series of options contracts over the same length of time.
A financial institution writing an interest rate cap is creating interest rate risk for itself. The institution normally would hedge against this risk by taking out an offsetting interest rate cap with another institution. Another possibility would be to take out an interest rate swap exchanging obligations on a floating rate loan for those on a fixed-rate loan. The institution could also hedge the risk by selling futures short on the financial futures market.
An interest rate cap has an apparent cash flow disadvantage compared with an interest rate swap because the premium is payable up front. This up-front payment also might be seen as an advantage because the cost of the cap is certain from the outset. Some derivative instruments taken out to hedge against interest rate risk might involve a higher cost at a later stage. For example, an interest rate swap to exchange the floating rate obligations for those on a fixed rate loan would not allow the holder to benefit from lower interest rates. Taking out an interest rate cap does not prevent the holder of the cap from enjoying the benefit if interest rates go down.