A rate cap is an agreement between two parties providing the purchaser, who pays a premium, an interest rate ceiling or ‘cap’. This financial instrument is primarily used by borrowers of floating rate debt in situations where short term interest rates are expected to increase. Rate caps can be viewed as insurance, ensuring that the maximum borrowing rate never exceeds the specified cap level. An interest rate floor on the other hand, guarantees the purchaser, who pays a premium, a lower bound for the rate of interest received on an investment. This may be used in conjunction with a floating rate note (FRN) to ensure a minimum return on investment. Floors are used in times of decreasing short term interest rates by money managers trying to obtain higher cash returns on floating rate investments.
