An option in which the cap level is based on the last rate set for the underlying floating rate (LIBOR). If the floating rate moves above a preset trigger threshold in the resetting period, the cap strike for the remaining option will be increased by a prespecified amount, up to a maximum level.
A momentum cap is an ideal protective hedge for borrowers or issuers. If rates remain low as expected, the premium cost would be lower than that of an ordinary cap. If rates rise, the strike will rise at a slow pace, and only up to a maximum level. Therefore, momentum caps are particularly useful for firms which seek rate protection from unexpected rate rises, but at a low initial cost. Generally, the option embedded in a momentum cap is cheaper than a normal option.
Momentum caps are also referred to as adjustable strike caps or ratchet caps.
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