A cap is a call option on a specified interest rate such as LIBOR, Euribor, the US prime rate, or a commercial paper rate. The interest payment on a long cap (to the holder of a cap), in case of exercise, would be determined based on the notional amount. It represents a predetermined dollar principal that is used only for calculation purposes, i.e., it is never paid but only serves as a basis for calculation of the interest payment. An example is a 2-year cap with a notional amount of USD 70 million, a reference rate of 6-month LIBOR and a cap rate of 5% (annualized). Every six months, if the current market rate (LIBOR) is above the cap rate (cap strike), the cap seller will pay the cap holder the difference (LIBOR- strike) times the notional amount. Otherwise, not payment is made:

Cap payment = (LIBOR – cap strike) × notional amount

Where: LIBOR > cap strike