By purchasing a Cap, the investor purchases security against the growth of interest rates.
The amount of the individual payments is thus floating, and depends on the current interest rate – generally the six-digit PRIBOR. Hence, if the 6M PRIBOR exceeds a limit agreed upon beforehand, the bank will pay the client the amount equal to this excess. If however the reference rate (6M PRIBOR) is under the agreed limit, the opposite payment will not take place! The result of this fact is mainly the following differences from an interest swap: the definite advantage of the buyer (generally a client) must be compensated in some way for the seller (generally the bank). In its simplest form, this settlement is made once, initially, on the day that the contract takes effect, by paying a commission.
In this basic form, the bank does not bear any of the credit risk of the client – no credit line is necessary, and if one has already been approved the remainder of its available amount will not decrease the Cap. If there is no initial payment (= commission) desired, this commission can be paid gradually during the course of the duration of the Option.