Caplet

A caplet is a European-style call option used by traders who want to hedge against higher interest rates.

Caplets are usually based on an interbank interest rate such as LIBOR. For example, if a trader buys a caplet they would be paid if LIBOR rose above their strike price; they would receive nothing if LIBOR fell below their strike price. Traders time a caplet's expiration to coincide with a future interest rate payment. They are usually combined in a series to create a "cap" so as to manage longer-term liabilities.

Caplets and caps are used by investors to hedge against the risks associated with floating interest rates. Imagine an investor who has a loan with a variable interest rate that will rise or fall with LIBOR. Assume that LIBOR is currently 6% and she is worried that rates will rise before the next interest payment is due in 90 days. To hedge against this risk, she can buy a caplet with a strike rate of 6% and an expiration date at the interest payment date. If LIBOR rises, the value of the caplet option will also rise. If LIBOR falls, the caplet could become worthless. 

A caplet's value is calculated as:

Max((LIBOR rate – caplet rate) or 0) x principal x (# of days to maturity/360)

If LIBOR rises to 7% by the interest payment date and the investor is paying quarterly interest on a principle amount of $1,000,000, then the caplet will pay off $2,500. You can see how this payoff was determined in the following calculation:

= (.07 – .06) x $1,000,000 x (90/360) = $2,500

If an investor needs to hedge a longer-term liability with several interest payment due dates then several "caplets" can be combined into a "cap." For example, let's assume an investor has a two-year loan with interest-only, quarterly payments. She can purchase a two-year cap based on the three-month LIBOR rate. This investment is composed of seven caplets and each caplet covers three months. The price of the cap is the sum of the price of each of the seven caplets.