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An interest rate cap allows the buyer of the cap to be compensated if interest rates...

An interest rate cap allows the buyer of the cap to be compensated if interest rates rise above a reference rate. The buyer has to pay a periodic premium to obtain this protection. When an RMBS transaction has a pool of floating-rate loans, what type of protections does an interest rate cap provide? Give an example of an interest rate cap

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Answer #1

The interest rate cap is a very useful in case of RMBS transaction because the borrower would be paying the interest based upon the floating rate. Since the interest rate keeps on increasing the borrower needs to be protected against the unlimited increase. This protection is provided by the interest rate cap since it limits the amount of increase in the interest rate.

Example: An agreement to receive a payment in each month that the LIBOR rate goes above 2%

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