Interest Rate Cap

An interest rate cap is a type of derivative contract that provides the purchaser with protection against rising interest rates. It sets a maximum (or cap) level on the interest rate on a floating or variable rate loan. If interest rates rise above this cap, the seller of the cap (often a bank) compensates the buyer for the difference. In commercial real estate, caps are commonly purchased by borrowers to limit the risk of rising interest rates on variable-rate debt.

Modeling an interest rate cap involves modeling the floating rate debt, but with a MIN() function that ensures the all-in rate does not exceed the cap during the term of the cap.