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What is CAP in interest rate?
A CAP is a structure that offers interest rate insurance to individuals, it establishes the highest or largest amount of interest that people can receive on a financial instrument. A CAP benefits both parties in a financial contract in such a way that a receiver is protected from the risk of low interest and the payor is protected from excess payment of interest. In a situation of drop in interest rate, clients can still benefit and in an occasion of increase in interests, the payor does not pay too much. In large markets, there are established CAPs that participants follow but in a limiter-term contract, the seller can set a rate for the CAP. The rate set by the seller must also align with the existing benchmark in the market.
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How Does an Interest Rate Cap Work?
A CAP is essential in any financial contract, it states the interest rate that must be followed whether there is an increase of decline in the market interest rates. Both parties in a financial contract benefit from an interest rate CAP. In most cases, borrowers who perceive a likely increase in interest rate are reassured through CAP that increase in interest will not impede their ability to make debt payments. A CAP can also serve as a financial derivative between two parties which gives the purchaser of the CAP holds the option (right) to receive payment from the seller when the CAP rises to a desired level. This means in the case of fall in interest rates, the purchaser loses money.