What is an interest rate cap?
An interest rate cap acts like insurance against high interest rates.
Caps are typically purchased by borrowers with variable rate loans, to protect against the possibility of interest rates rising above an agreed maximum, the cap rate.
The cap buyer pays a premium for the cap in exchange for extra income when interest rates rise above the cap rate. The further that rates exceed the cap rate, the greater the extra income from the cap. The cap income offsets the higher interest cost of the variable loan.
When rates are below the cap rate, the borrower receives no income from the cap but simply pays the lower variable rate.
The risk of a cap is that the buyer pays a premium for the cap but receives nothing in return, for example if interest rates remain below the cap rate for the duration of the instrument.
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