1) an OTC interest rate derivative, or simply a contract on an interest rate whereby the seller (or the writer) pays the buyer, at periodic payment dates, the positive difference between the market interest rate (the reference interest rate) and the agreed strike price (the cap). The interest rate cap is equivalent to a series of call options (caplets) each written on an individual forward interest rate. For the buyer to purchase a cap, a premium should be paid to the seller. Cap expiration usually ranges between 1 and 7 years. The periodic payment may be monthly, quarterly or semiannual.
2) a hedging tool that combines a number of interest rate call options. By a cap, a borrower with a floating rate loan can hedge against interest rate increases.
