Cap

Borrowers can provide themselves a form of insurance by purchasing a financial derivative called a cap. A party selling a cap agrees to pay the interest on an adjustable-rate loan after the interest rate exceeds a certain percentage. For example, if a borrower purchased a cap at 5 percent and the interest rate rose to 7 percent, the seller of the cap would have to pay two points of interest on the loan.

Collar

A collar is a combination of a floor and a cap that hedges an investor’s bet by insulating her from changes in the interest rate, either up or down. A lender using a cap will generally purchase a floor and sell a cap, while a borrower will sell a floor and purchase a cap. Collars are advantageous because they pay for themselves; however, in exchange, the investor limits the amount of his potential gains.

Swaps

A swap is a financial derivative in which one investor trades payments derived from interest on a loan for another investor’s regular payments of cash. The interest rate payments are generally pegged to an index, while the cash payments are fixed. In this way, an investor can essentially sell profits from the interest rate to another investor, causing him to take on the risks of severe fluctuations. Swaps can also be structured so that one interest rate is traded for another.

Futures

References

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