Interest Rate Caps And Floors

Caps and floors can be used to hedgeagainst interest rate fluctuations.

Interest rate caps and floors.

In both products the buyer of the contract. Interest rate floors and interest rate caps are levels used by varying market participants to hedge risks associated with floating rate loan products. An interest rate floor is an agreement between the seller or provider of the floor and an investor which guarantees that the investor s floating rate of return will not fall below a specified level over an agreed period of time. On the other hand if you invested in a floating rate note and receive floating rates you ll want to protect yourself against too low rates.

In other words the. For example a borrower who is paying the libor rate on a loan can protect himself against a rise in rates by buying a cap at 2 5. Similarly rate floors protect the banks profit margins if rates go into the tank. A cap is an option.

Caps and floors are based on interest rates and have multiple settlement dates a single data cap is a caplet and a single date floor is a floorlet. An interest rate floor is an agreed upon rate in the lower range of rates associated with a floating rate loan product. Interest rate caps and floors are option like contracts which are customized and negotiated by two parties. Caps floors and collars 2 interest rate caps a cap provides a guarantee to the issuer of a floating or variable rate note or adjustable rate mortgage that the coupon payment each period will be no higher than a certain amount.

It is simply a series of call options on a floating interest rate index usually 3 or 6 month libor. An interest rate floor is similar to an interest rate cap agreement. Borrowers are interested by caps since they set a maximum paid interest cost. It has value only when the rate is above the guaranteed rate otherwise it is worthless.

In this case you ll want to buy a so called floor. Investopedia delivers a succinct explanation. Interest rate floors are often used in the adjustable rate mortgage arm market. An interest rate cap is an otc derivative where the buyer receives payments at the end of each period when the interest rate exceeds the strike whereas an interest rate floor is a similar contract where the buyer receives payments at the end of each period when the interest rate is below the strike.

Caps and floors are like calls and puts and they are related through a parity relation which relates them to the value of a corresponding swap.