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The asymmetric nature of the contract leads to two types of contracts:
Cap. The most popular is the interest rate Cap, which is used to set a maximum level, or Cap, on a short-term rate index (for example, LIBOR). The purchaser of the Cap is compensated if the index goes above a certain level, known as the strike level.
Floor. The other type of contract is the interest rate Floor, which sets a minimum rate on some index. An asset manager may purchase a Floor to guarantee some minimum return on a floating-rate asset. For a predetermined fee, the guarantor of the Floor would pay the purchaser whenever the index is below a certain level on a given set of dates.
For example, if the Strike Rate on a Floor contract is 5%, and on the reset date the underlying security coupon rate is 4.5%, then the Floor contract accrues at .5% (Strike Rate - underlying coupon rate). If the coupon rate on the underlying security is 5.5% on the reset date for the same Floor contract, then the security accrues at 0% because the underlying security coupon rate is greater than the Strike Rate.
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