Interest Rate Cap

An interest rate cap is a derivative instrument that sets a maximum interest rate on a floating-rate financial instrument, such as a bond or loan. If the underlying reference rate (for example SOFR or EURIBOR) rises above the agreed cap strike, the cap pays the difference, calculated on the notional amount.

Interest rate caps are commonly used by borrowers, issuers, and treasury teams to protect against rising interest rates and to limit exposure to increasing financing costs.

How an Interest Rate Floor Works

An interest rate cap consists of a series of option-like components known as caplets, each linked to a specific interest period.

• The reference rate is observed on each reset or payment date
• If the reference rate is below the cap strike, no payment occurs
• If the reference rate is above the cap strike, the seller of the cap pays the excess

Payoff (simplified):

Payoff (simplified):
max(Reference Rate - Cap, 0) × Notional × Day Count Fraction

Why Use an Interest Rate Cap?

Interest rate caps are typically used to:

• Limit exposure to rising interest rates
• Stabilize interest expense on floating-rate debt
• Improve budget certainty and cash flow forecasting
• Reduce refinancing and rate volatility risk

Caps are frequently embedded in floating-rate bonds or loans issued by corporates, financial institutions, and public sector entities..

Interest Rate Floor as an Embedded Derivative

When an interest rate cap is embedded in a debt instrument and is not closely related to the host contract, accounting standards may require it to be separated and accounted for independently. Typical examples include:

• Floating-rate bonds with non-market cap levels
• Loans where the cap significantly alters the interest profile

In such cases, the cap is treated as an embedded interest rate derivative and must be measured at fair value.

Interest Rate Floor vs. Interest Rate Cap

An interest rate cap protects against rising interest rates, while an interest rate floor protects against falling interest rates. Together, caps and floors define upper and lower bounds on floating interest payments and are often combined into collars or structured debt instruments.

An interest rate cap is a key risk management tool for limiting exposure to rising interest rates. Whether used as a standalone derivative or embedded in a bond or loan, proper valuation and accounting treatment are critical for effective treasury and financial reporting.