CAPs are a ceiling or upper limit of a interest rate. It is one of the interest rate guarantee instruments used to limit the risk of rate fluctuations.
They could be classified as interest rate insurance, which, as well as protect the client from possible increases in the Euríbor, also allow them to benefit from the declines of the indicator.
What are CAPs?
CAPs are a financial derivative, where the buyer acquires the right for the seller to pay the difference in the event that it is positive, between the type of interés reference in force on specific future dates and the interest rate established in the option, exercise price, through the payment of a premium and for a theoretical nominal amount.
These agreements have a limited duration between two parties, which are generally a financial institution and a client, in which a reference interest rate and a guaranteed interest rate are specified on a specified amount.
It can become an interesting option for economic agents who plan to borrow at a variable rate and who maintain upward expectations of interest rates.
The CAP is the same as an interest rate insurance, which presents a coste that provides us with security in case of increases in the Euribor and allows us to benefit from the decreases.
They are also common in the field of mortgages. The mortgage CAP, when contracting it, also sets a ceiling before the increase in the euríbor, and when it rises above the established rate, the entity agrees to return the difference to the customer.
Although they are defined as CAP insurance, they are a financial derivative with which they can establish interest rate limits on Mortgages variables.
Difference between CAP and SWAP
In relation to variations in interest rates and insurance, SWAPs are also frequent. This term refers to the exchange of a variable interest rate for a fixed rate. In each period, if the fixed rate is above the variable rate, the customer will pay the difference. Otherwise, it should be the financial institution that will face the payment.