Editing Interest rate cap and floor (section)

{{short description|Type of interest rate derivative}}

In [[finance]], an '''interest rate cap''' is a type of [[interest rate derivative]] in which the buyer receives payments at the end of each period in which the interest rate exceeds the agreed [[strike price]].  An example of a cap would be an agreement to receive a payment for each month the [[LIBOR]] rate exceeds 2.5%.

Similarly, an '''interest rate floor''' is a derivative contract in which the buyer receives payments at the end of each period in which the interest rate is below the agreed strike price.

Caps and floors can be used to [[hedge (finance)|hedge]] against interest rate fluctuations. For example, a borrower who is paying the LIBOR rate on a loan can protect himself against a rise in rates by buying a cap at 2.5%.  If the interest rate exceeds 2.5% in a given period the payment received from the derivative can be used to help make the interest payment for that period, thus the interest payments are effectively "capped" at 2.5% from the borrowers' point of view.