Interest rate cap

Under a cap arrangement, the seller of the cap will make payments to the buyer if interest rates rise above an agreed rate. The payment to be made is calculated by reference to a notional principal sum over an agreed term. In return, the buyer pays the seller a premium up front for entering into the cap. The buyer, in return for the premium, is able to insure against the consequences of interest rates rising above a pre-determined level but can still take advantage of falls in rates.