An interest rate cap is an agreement between two parties providing the purchaser an interest rate ceiling or 'cap' on interest payments on floating rate debts. The rate cap itself provides a periodic payment based upon the positive amount by which the reference index rate (e.g. 3m LIBOR) exceeds the strike rate. This financial instrument is primarily used by issuers of floating rate debts in situations where short term interest rates are expected to increase. Rate caps can be viewed as insurance, ensuring that the maximum borrowing rate never exceeds the specified cap level. In exchange for this peace of mind, the purchaser pays the financial institution a premium.
An interest rate floor on the other hand, guarantees a lower bound for the rate of interest received on an investment, when used in conjunction with a long position in a Floating Rate Note (FRN). The rate floor itself provides a periodic payment based upon the positive amount by which the strike rate exceeds the reference rates. Sometimes these rate guarantees are embedded into financial instruments such as structured medium term notes. Floors are used in times of decreasing short term interest rates by money managers trying to obtain higher cash returns on floating rate investments. Compensation is paid to the seller in return for the interest rate guarantee.