An option on a cap. In other words, a caption is an option to buy or sell an interest rate cap whereby the holder has the right, without the obligation, to purchase or sell a cap with an agreed-upon strike rate on (if the caption is European-style) or before and up to (if the caption is American-style) a given date against a specified premium. An investor purchasing a caption (which confers on him the right to enter into an interest rate cap) would gain in case the floating interest rate on the underlying instrument (a note) increases above a specific level. Otherwise, that investor can simply choose to refrain from purchasing the interest rate cap. As the caption goes unexercised, the investor loses the premium, but at the same time, he is said to have hedged interest rate risk and volatility risk.

For example, a two-year cap has a premium of 150 basis points. An investor could currently buy an at-the-money six-month caption for 15 basis points. The caption is an option to buy the cap at or before the expiration date at which the option’s life ends. If the cap is in-the-money at expiration, the holder of the caption would exercise the option to purchase the cap for 150 basis points, whereby gaining the amount by which the cap is in the money (say 30 basis points, for a cap worth 180 basis points). The total cost to the caption buyer is, therefore, the caption cost plus the cap cost, i.e., 150 plus 15 or 165 basis points). The additional cost an investor incurs for a caption is the price he pays against being able to hedge or mitigate upside interest rate risk at a future date.

The caption is also known as an interest rate caption.