A call option on the inflation rate implied by the consumer price index (CPI) or any similar index. A stream of consecutive caplets on the same underlying price index constitutes an inflation cap. In other words, an inflation cap is a bundle of inflation caplets each comes into effect one the previous one expires. By nature, caplets are not directly traded and hence their prices are not observable. Rather, caplet prices must be implied from the observed cap prices. When an inflation caplet is traded, the buyer and the seller agree an expiration date, a strike price (or rate) and a notional— a hypothetical amount which the seller (caplet short) agrees to insure for the buyer (caplet long). The buyer pays the seller an upfront premium -the option price. On expiration, the seller then pays the buyer the difference between the realized inflation rate and the strike rate multiplied by the notional amount, only if realized inflation exceeds the strike rate. Otherwise no money changes hands (i.e., payoff is zero).

The payoff of an inflation caplet resembles the payoff of a vanilla option on the return of a money market account if inflation rates are replaced with interest rates. Inflation caplets provide buyers with protection against upside risks.

Inflation caplets are also known as inflation-indexed caplets or inflation-linked caplets.