Interest Rate Cap

Upper limit on the maximum possible interest rate an insurance company will pay. If the market interest rates are below that maximum, the insurance company pays the market interest rate. In this way, the insurance company can hedge its interest rate exposure (risk that interest rates will rise or fall at some stipulated time), reflected by changes in the value of its assets on the balance sheets.

1. Contractual agreement protecting a borrower against a rise in interest rates. In exchange for an upfront fee paid when the funds are advanced, the lender agrees to hold any rate increases to a preset ceiling. For example, a borrower taking out a loan priced at a spread above the London Interbank Offered Rate (Libor) for 90-day Eurodollar deposits pays a cap fee to insure that the loan interest rate does not exceed a preset rate anytime during the life of the loan. The cap seller (the lender) agrees to pay the purchaser (the borrower) the difference between Libor and the Strike Price of the cap when Libor rises above that price. Interest rate caps are priced as option contracts, generally using an options pricing formula.

Most commercial lenders hedge against the interest rate risk created by the cap by buying an offsetting cap from another financial institution, by exchanging a floating rate obligation for a fixed rate obligation in an Interest Rate Swap, or by hedging-selling futures short-in the financial futures market. If interest rates happen to rise, the lender can then sell the futures contract at a higher price. The easiest way to buy protection against interest rate risk is to buy another cap. A bank selling a 15% cap on a $100 million loan could protect itself by taking an identical cap from another lender. Compare to Collar.

2. in an Adjustable Rate Mortgage, contractual limits on interest rate adjustments above an Index such as Annual Cap and Life of Loan Cap.