An interest-rate agreement is an agreement between two parties whereby one party, for an upfront premium, agrees to compensate the other at specific time periods if a designated interest rate, called the reference rate, is different from a predetermined level. When one party agrees to pay the other when the reference rate exceeds a predetermined level, the agreement is referred to as an interest-rate cap or ceiling. The agreement is referred to as an interest-rate floor when one party agrees to pay the other when the reference rate falls below a predetermined level. The predetermined interest-rate level is called the strike rate.

The terms of an interest-rate agreement include

  1. The reference rate
  2. The strike rate that sets the ceiling or floor
  3. The length of the agreement
  4. The frequency of settlement
  5. The notional principal amount

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