How does a cap differ from a floor in interest rate options?

A cap is an interest rate option that allows the buyer to benefit from rising interest rates, functioning as a call option on interest rates. This means that if interest rates exceed a predefined level, known as the strike rate, the holder of the cap receives payments based on the difference between the market rate and the strike rate. Essentially, it protects against increasing interest rates, which is particularly valuable in a rising interest rate environment.

Conversely, a floor is intended to provide protection against declining interest rates, and it operates as a put option on interest rates. When interest rates fall below a specified level, the holder of the floor receives payments from the seller, ensuring that they benefit from a minimum interest rate. This tool is useful for institutions or investors that want to guarantee a certain level of income from interest-producing assets.

Understanding these instruments is crucial for effective risk management in financial markets. The cap and floor serve opposite functions in managing interest rate risk—one hedges against rising rates while the other safeguards against falling rates. Thus, recognizing this distinction is important for anyone involved in managing interest rate exposure.