CAP (Finance) – Definition

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CAP (Finance) Definition

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.

A Little More on What is an Interest Rate Cap in Finance

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.

References for Interest Rate Caps

Academic Research on Interest Rate Caps

Price caps, rate-of-return regulation, and the cost of capital, Alexander, I., & Irwin, T. (1997).   This article makes a comparison of price drop effects and regulations concerning the rate of return on the risk the regulated utilities bear. The authors provide evidence that the regulation of price cap makes the company suffer high risks. So, it increases the cost of capital. The authors suggest that the company govern by price caps should be allowed to earn higher returns. Otherwise, they cannot attract new capital for investment. Their service quality will decrease.

Interest rate caps “smile” too! But can the LIBOR market models capture the smile?, Jarrow, R., Li, H., & Zhao, F. (2007). The Journal of Finance, 62(1), 345-382. The authors use three years of price data of interest rate caps and provide a detailed analysis of volatility smiles in the caps market. They design a model of multi-factor term structure using stochastic volatility and devise a cap prices formula. Though a 3 factor model of stochastic volatility prices well at the money caps, large negative jumps in the rates of interest are required. It consists of data that we cannot find at the money caps only.

Price caps in telecommunications regulatory reform, Johnson, L. (1989). As an alternative of Rate of Return regulation, the price caps have got importance because it creates a relation in cost and price. The firm makes savings efficiently. It ends the rate based bias. It restricts a company to hike prices and create a monopoly. The burden of the administration is lightened. It allows price flexibility to the firms that can move to socially optimal prices. The authors concluded that the price cap regulation can achieve results more than the traditional rate of return regulation.

Parallel trade, price discrimination, investment and price caps, Szymanski, S., & Valletti, T. (2005). Economic Policy, 20(44), 706-749. A wholesaler makes parallel trade of a product in a market that the manufacturer does not intend to. Consequently, it may stop the manufacturer to discriminate price between the markets that want to pay differently for the product. The manufacturer retains a right by a few legal regimes to stop the parallel trade. The authors check the parallel trade price implications where the manufacturers focus on product quality. Parallel trade is less desirable in pharmaceuticals than branded products. The price caps do not make the parallel trade harmful for welfare. The cost of parallel trade can be reduced using compulsory licensing.

Prohibitions, price caps, and disclosures: A look at state policies and alternative financial product use, McKernan, S. M., Ratcliffe, C., & Kuehn, D. (2013). Journal of Economic Behavior & Organization, 95, 207-223.  This paper contains a survey of NFCS data (National Financial Capability State by State) 2009. It evaluates the relationship in national AFS (Alternate Finance Services) and consumption of their 5 products, i.e. auto title loans, refund anticipation loans, payday loans, rent to own transactions and pawnbroker loans. Examining more than one product focuses on patterns. The findings are that more strict price caps and bans are attached to lower product use and are against the Hypothesis that price caps and bans on one product of AFS cause the consumers to use more AFS products.

Price caps and rate of return regulation, Ergas, H., & Small, J. (2001). Network Economics Consulting Group.  This article explains the difference in price caps and ROR regulations. They have a great influence on the regulated firm. The authors discuss the effect of resetting the regime parameters periodically which is basically the main characteristic of price cap regimes. Why do we need to reset them and on what grounds, the resulting incentives are different from the ones generated by ROR regulation?

Price-cap versus rate-of-return regulation, Liston, C. (1993). Journal of Regulatory Economics, 5(1), 25-48.  The regulation of ROR has been objected on the point that it gives inappropriate incentives to the regulated companies. They are also expensive to administer. Their substitute is price cap regulations in which the caps are imposed on the basis of price indices and technological change, under which the regulated company enjoys full freedom of pricing. The authors review the similarities and differences between the two. Practically, there is no difference in price cap regulation and rate of return. This is particularly true about the information requisites for the multi-product company. However, the price cap fails to tackle the real regulatory problem of whether a sector holds a natural monopoly overall or in part.

Price caps, rate-of-return regulation, and the cost of capital, Liston, C. (1993). Journal of Regulatory Economics, 5(1), 25-48.  This paper is based on the comparative analysis of the Rate of Return and Price Cap regulations effects on the risk the regulated utilities bear. It provides evidence that the price cap makes the company suffer high risks. So, it increases the cost of capital. The authors suggest that the company govern by price caps should be allowed to earn higher returns. Otherwise, they cannot attract new capital for investment. Their service quality will decrease.

An experimental investigation of soft price caps in uniform price auction markets for wholesale electricity, Vossler, C. A., Mount, T. D., Thomas, R. J., & Zimmerman, R. D. (2009). Journal of Regulatory Economics, 36(1), 44-59.  The research has been carried out to show the findings of an auction experiment using student participants and industry professionals who have a competition in the simulated wholesale market for the electricity. Getting motivation from the Federal Energy Regulatory Commission (FERC) intervention responding to the Meltdown of the California Spot Market, the authors evaluate the impact of a soft price cap inclusion in a uniform price auction, as a source of controlling high prices. When prices reach more than the soft cap, offer curve is flat whereas it is hockey shaped in uniform price auction. Ultimately, the offer curve makes market prices insensitive to the reductions in demand and cost price.

Price Caps: A Rational Means To Protect Telecommunications, Baumol, W. J., & Willig, R. D. (1989). Review of Business, 10(4), 3. In this paper, the authors highlight the role of price caps in the market and whether it is an effective and rational source of protection for the telecommunication industry or not.

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