Caps and floors are known as protected interest rate contracts. A protected interest rate contract can be defined as a contract that for a fee grants the right to benefit fully from a rate move in one direction, while being exposed to only limited risk if the rate goes the opposite way.
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.
Contrarily, if the Strike Rate on a Cap contract is 5%, and on the reset date the underlying security coupon rate is 4.5%, then the Cap contract accrues at 0% because the underlying security coupon rate is greater than the Strike Rate. If the coupon rate on the underlying security is 5.5% on the reset date for the same Cap contract, then the security accrues at .5% because the underlying security coupon rate is greater than the Strike Rate.
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