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Like Swaps, Caps and Floors provide price protection, but they have
the added advantage of providing benefit from favorable price
movements. They are commonly thought of as price "insurance," i.e.,
for a premium you are entitled to full price protection when prices
move through a specified level. A price Cap protects against rising
prices without sacrificing the advantage of falling prices. Floors
are the opposite of Caps; they guard against falling prices while
preserving upside price potential.
With a Cap or Floor, the full cost of the protection is predefined -
it is equal to the premium paid for the Cap or Floor. There are no
potential future costs related to price movements.
Price Floor example for Producers
Price Cap example for Consumers
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