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Cap

• Is the ceiling, upper limit price, or interest rate which would be paid. It is analogous to a long call position.

• A Cap is a call option on interest rates. If the interest rates rise above the cap rate, then the seller compensates the buyer for the difference in interest rates times a notational amount. The cap can in effect convert floating rate liabilities into fixed rate liabilities. The cap on home mortgages is an example of an interest rate cap. A series of options in which the writer guarantees the buyer, a payor of floating, that he will pay the buyer whatever additional interest he must pay on his loan if the rate on that loan goes above an agreed rate, X.

• An upper limit on the interest rate on a floating-rate note.

 
 Embedded terms in definition
 Call option
Call
Floating rate
Interest rate cap
Interest rate
Interest
Liabilities
Limit price
Limit
Long
Note
Options
Option
Position
Series
Will
Writer
X
 
 Referenced Terms
 Adjustable rate mortgage: Is a loan which has a coupon or interest rate that is subject to change on predetermined reset dates. These loans use interest rate indices as the benchmark rate. Adjustable Rate Mortgages come in many variations. Typically, the reset dates recur every 1, 3, or 5 years; but there are other periods used as well. These loans may have Cap and floor features which constrain each reset change in interest rates. There may also be lifetime cap and floor features. Adjustable Rate Mortgages may be strictly amortizing though some have negative amortization features.A mortgage whose interest rate changes periodically based on the upward or downward movement of a specified benchmark, e.g. six month or one-year Treasury bills.

 Collar: Is the combination of a long Cap position and a short Floor position. It is sometimes called a range forward or a fence. Generally, it is structured so that the net cost of the collar is zero or close to zero. This means that the debit expense for the long cap premium is offset by the credit received for the short floor premium. This term is also used to define the prepayment speed range for a credit instrument.An upper and lower limit on the interest rate on a floating-rate note.A Collar also refers to a combination of Cap (call option on interest rates) and floor (put option on interest rates). An investor who holds a collar is in effect protected from interest rate increases or interest rate declines.Buy a call and sell a put. If a firm buys jet fuel and wants protection against jet fuel increases, it can buy a call option with a higher exercise price than the current price and sell a put option (with lower exercise price than the current price) and limit the price fluctuations to be in between the exercise price of the call and the exercise price of the put.

 Collar: Is the combination of a long Cap position and a short Floor position. It is sometimes called a range forward or a fence. Generally, it is structured so that the net cost of the collar is zero or close to zero. This means that the debit expense for the long cap premium is offset by the credit received for the short floor premium. This term is also used to define the prepayment speed range for a credit instrument.An upper and lower limit on the interest rate on a floating-rate note.A Collar also refers to a combination of Cap (call option on interest rates) and floor (put option on interest rates). An investor who holds a collar is in effect protected from interest rate increases or interest rate declines.Buy a call and sell a put. If a firm buys jet fuel and wants protection against jet fuel increases, it can buy a call option with a higher exercise price than the current price and sell a put option (with lower exercise price than the current price) and limit the price fluctuations to be in between the exercise price of the call and the exercise price of the put.

 Equity collar: The simultaneous purchase of an equity floor and sale of an equity Cap.

 Equity hedge funds: Try to long position themselves in stronger or outperform issues while selling short weaker or poorer prospect securities. Variations of this are: trading large Cap issues versus small caps; using derivatives for enhanced returns; specializing in program trading; or using leverage to magnify returns.

 
 Related Terms
 Equity cap
Interest rate cap
Market cap or market capitalization
Power cap

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