What is an Interest Rate Cap?
An Interest Rate Cap is a derivative product based on a contractual agreement between the Borrower, the buyer, and the Bank, the seller, to hedge against rising interest rates. The Bank agrees to insure the Borrower against a rise in the rate of interest above an agreed strike rate, the Cap. The Buyer receives a payment for each period the rate exceeds the strike price, effectively setting a limit on its interest rate payments. In exchange for the Cap, the Borrower is required to pay a cash premium to the Bank, usually upfront.
The purpose of the Cap is to establish a ceiling on the cost of finance for a Borrower with floating rate borrowings. This allows the Borrower to enjoy interest rates lower than the Cap and the protection of the strike rate should they rise.
How does it work?
On the reset date, if the rate is above the Cap strike rate, the Bank will pay the Borrower the difference. If the rate is equal to or below the Cap strike rate, the Borrower will not receive a payment.
- It provides the Borrower with a pre-agreed maximum rate of interest
- The Borrower benefits from floating rates lower than the Cap strike rate
- There are no additional costs arising from early termination. The Borrower will be entitled to receive any residual value attributable to the Cap
- The Borrower will incur a premium cost, usually paid up front
- If the floating rate remains below the Cap strike rate during the tenor of the Swap, the Borrower may feel they received no value
Interest rate cap example: