Cap & Floor
Also known as: Interest rate cap, Floor, Caplet/floorlet
A ceiling or floor on floating interest — insurance against rates going where you can't afford them to.
1 · SnapshotThe one idea to remember
2 · BeginnerWhat is it, really?
An interest rate cap is a ceiling on a floating rate. A borrower with a floating loan buys a cap struck at, say, 4%: every period the market rate fixes above 4%, the cap pays them the difference. Below 4%, nothing happens and they simply enjoy the lower rate.
It's insurance, priced like insurance: an upfront premium buys protection for the life of the deal. Unlike a swap, which locks a fixed rate and gives up all benefit from falling rates, a cap protects the downside while keeping the upside — that asymmetry is what the premium pays for.
A floor is the mirror image: a minimum rate, bought by floating-rate receivers (lenders, FRN investors) fearing rate collapses.
Point at a line to pick it out from the others.
a paymentonly if a condition is metnot a payment
A cap is not one option. It is a strip of them, one per period, each settling on its own.
At the start
- The borrower → The seller Paid up front for the whole strip, or amortised into the loan margin. It is the most the buyer can lose.
Each period, if rates are high
- The seller → The borrower Only when the index sets above the cap rate. The payment covers exactly that period, on the agreed notional.
Each period, if they are not
- The seller → The borrower The caplet for that period expires unused. The premium is not refunded and the borrower simply pays their ordinary floating rate.
The floor, in reverse
- The borrower → The seller Selling a floor funds the cap and produces a collar — at the cost of giving up the benefit if rates fall a long way. Two options, two directions, one premium netted.
- Asset class
- Rates derivatives
- Instrument type
- Strip of rate options
- Traded
- OTC
- Typical users
- Borrowers, real-estate funds, FRN investors
Which risks decide the outcome
Not how risky this is, and not a rating — there is deliberately no total. It says which of five failure modes drives what happens here, in the same order on all 129 products so they can be compared. This publication's own reading; see the notice below.
- Marketdecides it
- Creditmatters
- Liquiditybarely applies
- Fundingbarely applies
- Operationalmatters
What decides it here. The buyer's loss is the premium and nothing more, which is the point: it protects a borrower without giving up the benefit if rates fall.
3 · IntermediateHow it works in practice
A strip of little options
A 5-year quarterly cap is really 20 independent options ("caplets"), one per reset: each pays \(\max(r_i - K, 0)\times\delta\times N\) at its period's end. The cap premium is simply the sum of caplet values — periods further out cost more (more time for rates to wander).
Structures built from caps and floors
- Collar: buy a cap, sell a floor — cheaper (often zero-cost) protection, rate confined to a band.
- Corridor: buy a cap, sell a higher-strike cap — capped protection at lower premium.
- Embedded: floored FRNs, capped mortgages and structured notes all contain these options implicitly.
Market colour
Caps became front-page finance in 2022–23: US commercial real-estate loans typically require borrowers to hold caps, and when rates jumped, replacement caps that had cost $100k suddenly cost millions — a squeeze that materially affected property refinancing.
4 · AdvancedPricing & valuation
Caplet pricing
Each caplet is a call on its forward rate \(f_i\), a martingale under its own forward measure. Bachelier (normal) pricing, today's standard:
What the symbols mean
- Cthe price of a call option
- ta point in time
- deltaa small change in whatever follows
- Pa price, or a present value
- Tmaturity, in years
- Kthe strike: the price written into the contract
Under RFR benchmarks the "rate" is compounded-in-arrears, so the option's effective observation extends into the accrual period — vol accrues partly during the period itself, handled by an adjusted variance term (\(T_i \to T_i + \tfrac{\delta}{3}\)-style corrections in simple models).
Vol surfaces and stripping
Markets quote flat vols — one vol repricing the whole cap — per maturity and strike. Desks strip these into forward (spot) caplet vols, the genuinely informative objects, via bootstrap: each maturity's cap minus the previous cap's caplets reveals marginal caplet value. The caplet surface and the swaption cube must cohere; their misalignment is traded (cap/swaption arbitrage) and is a standard calibration tension in term-structure models.
Caps vs. swaptions — the correlation wedge
A cap is a basket of options on individual forwards (no correlation dependence); a swaption is an option on a basket (average) of forwards — worth less when forwards decorrelate. The price gap between a cap and the matching swaption straddle strip prices inter-forward correlation, one of the few places it is directly observable.
The formulas above are standard textbook formulations, simplified for teaching. They explain the mechanism — they are not a valuation tool, and they will not reproduce a dealer’s price.
5 · Desk notesHow practitioners think about it
Now say it back
Close the page and give Cap & Floor in four sentences. It takes a minute and it is the only way to find out whether reading it was enough.
- Who wants what — two parties wanted opposite things badly enough to write it down.
- What the contract obliges, and when — not the payoff; the obligation.
- Where the money comes from — name the source, or you have described a hope.
- What makes it lose — the ordinary way, not the dramatic one.
Put Cap & Floor beside any other instrument →
Where this instrument shows up elsewhere
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