The Effective Interest Rate With and Without a Cap
(1) A provision of a debt contract or a separate option agreement that, in effect, puts a ceiling or 'cap' on an interest rate. A floating rate borrower may buy an interest rate cap that limits interest cost to, say, eight percent even if rates go much higher. The form of the ceiling may vary. An embedded cap may actually impose a rate ceiling. A separate contract may pay the holder of the cap an amount equal to the amount by which market rates exceed the cap rate (times the notional principal). A cap usually consists of a strip or series of caplets- options putting a ceiling on rates for each rate reset period over the life of the cap. Also called Interest Rate Cap, Ceiling. See also Caplet, Caption, Floor (1) (diagram). (2) An option which puts a ceiling on rates or returns in foreign exchange or equity markets.
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