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Caps and floors are options that provide the right, but not the obligation, to enter into a long or short position at a specified price.
Caps and floors are similar to swaps since they provide price protection at a predetermined level. However, caps and floors are different from swaps in that they allow producers and end users to benefit from favorable price changes. The buyer of the cap or floor pays an up-front cash premium for this price protection. With cap and floor purchases, all risks are predefined; the premium paid for the option will always be the maximum "loss" or "cost" incurred by the buyer.
- Caps are usually bought by energy end users. Caps, sometimes referred to as "call options," are arranged in conjunction with the physical purchase of a commodity in order to establish a maximum price an end user will pay for that commodity. They provide full protection from rising prices. In addition, caps allow end users to benefit fully from decreases in the price of the commodity.
- Floors are usually bought by producers. Floors, sometimes referred to as "put options," are arranged in conjunction with the physical sale of an energy commodity in order to establish a minimum price a producer receives for its commodity.
The buyer of the cap or floor agrees to pay a predetermined cash premium for this price protection. For this premium, the buyer minimizes exposure to adverse price movements while retaining the ability to capitalize fully on advantageous price moves.
producer application
end user application
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