An interest rate cap allows the buyer of the cap to be compensated if interest rates rise above a reference rate. The buyer has to pay a periodic premium to obtain this protection

When an RMBS transaction has a pool of floating-rate loans, what type of protections does an interest rate cap provide?

An interest rate cap provides protection against floating-rates rising above a reference rate by alleviating losses. An interest rate cap is a derivative in which the buyer receives payments at the end of each period in which the interest rate exceeds the agreed strike price.

An example of a cap would be an agreement to receive a payment for each month the LIBOR rate exceeds a certain percentage. Too much of an increase in LIBOR can make securities with fixed payment fall in value.

There are interest rate derivatives such as interest rate swaps and interest rate caps employed in nonagency MBS structures that are not allowed in agency MBS structures. These interest rate derivatives can be used when there is a mismatch between the character of the cash flows for the loan pool and the character of the cash payments that must be made to the bond classes. For example, some or all of the bonds classes may have a floating interest rate, whereas all the loans have a fixed interest rate. In our problem, there is not a perfect match due to some involvement with fixed rates. Thus, caps can alleviate this matching problem.