An interest rate cap that protects its holder, during a given period of time, against upward movement in the base rate beyond a specific level (cap). This instrument is designed to contain the cost of interest rate increases, while allowing the holder to retain gains from interest rate decreases. Typically, investors buy base rate caps in conjunction with floating-rate loans. In practice, an agreement can be forged with a lender on a floating-rate loan given at a fixed cap rate for a predetermined period of time. For example, two parties may agree on a loan of $10 million at a capped base rate of 5% for five years. During this period, the borrower will be exposed to potential rises in rates on the floating-rate loan. However, the base rate cap means that the counterparty to the cap will pay the borrower any excess over the average base rate observed above the agreed cap rate.
Derivatives
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