To hedge variable-rate loans against rising interest rates.
A cap hedges a variable-rate loan ( e.g. a mortgage) against rising interest rates. The customer continues to profit from stable or falling interest rates. If they rise above the agreed upper interest limit the bank pays the customer the difference between the agreed basic rate and the market interest rate. Caps are normally concluded for several years, with the interest rate fixed several times over the duration, normally every six months. On each fixing date, the market interest rate is compared with the agreed cap rate. If Libor is greater than the cap rate, the bank pays the cap purchaser the difference six months later. A premium is paid for a cap.
You are hedged against rising interest rates whilst you continue to profit from stable or falling interest rates.
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