capfloor

A cap and a floor are types of interest rate derivatives that provide protection against movements in a reference rate, typically the short-term rate on a floating-rate loan. A cap pays when the reference rate exceeds a specified cap rate, while a floor pays when the rate falls below a specified floor rate. Both are usually structured as a series of options across the reset dates of the loan.

A cap floor, sometimes written cap/floor, is an instrument that combines these features to bound payments within a defined range. In its basic form, it offers protection against rising rates (via the cap) and against falling rates (via the floor), effectively creating a corridor for interest payments. The product can be used as a single combined contract or as two separate option legs bought together. A collar is a related structure achieved by buying a cap and selling a floor, often to reduce the net premium.

Pricing and valuation: The value of a cap floor equals the sum of the values of its cap and floor legs. Each leg is priced as a series of options on forward rates, commonly using models such as Black’s formula in a lognormal framework or other interest-rate models. Valuation depends on the term structure, rate volatility, frequency of resets, day-count conventions, and notional. Market liquidity for cap and floor contracts varies by jurisdiction and instrument type.

Use and applications: Cap floors are used by borrowers seeking protection against adverse moves in rates while preserving some upside, or by lenders and investors managing exposure to floating-rate assets. They are common in corporate financing, mortgage markets, and structured notes.