that the seller agrees to pay the buyer if the reference rate exceeds the strike rate. An interest rate floor specifies that the seller agrees to pay the buyer if the reference rate is below the strike rate. The terms of an interest rate agreement include: (1) the reference rate; (2) the strike rate that sets the cap or floor; (3) the length of the agree- ment; (4) the frequency of reset; and (5) the notional amount (which determines the size of the payments). If a cap or a floor are in-the-money on the reset date, the payment by the seller is typically made in arrears.   12The term cap and floor is not to be confused with floating-rate note products that have caps and/or floors which restrict how much a floaters coupon rate can float.     Some commercial banks and investment banks now write options on interest rate caps and floors for customers. Options on caps are called captions. Options on floors are called flotions.   Caps A cap is essentially a strip of options. A borrower with an existing inter- est-rate liability can protect against a rise in interest rates by purchasing a cap. If rates rise above the cap, the borrower will be compensated by the cap payout. Conversely, if rates fall the borrower gains from lower fund- ing costs and the only expense is the upfront premium paid to purchase the cap. The payoff for the cap buyer at a reset date if the value of the ref- erence rate exceeds the cap rate on that date is as follows:   Notional amount ´ (Value of the reference rate - Cap rate) ´ (Number of days in settlement period/Number of days in year)   Naturally, if the reference rate is below the cap rate, the payoff is zero. A cap is composed of a series of individual options or caplets. The price of a cap is obtained by pricing each of the caplets individually. Each caplet has a strike interest-rate that is the rate of the cap. For example, a borrower might purchase a 3% cap (Libor reference rate), which means that if rates rise above 3% the cap will pay out the difference between the cap rate and the actual Libor rate. A one-year cap might be composed of a strip of three individual caplets, each providing protection for succes- sive three-month periods. The first three-month period in the one-year term is usually not covered, because the interest rate for that period, as it begins immediately, will be known already. A caplet runs over two peri- ods, the exposure period and the protection period. The exposure period runs from the date the cap is purchased to the interest reset date for the next borrowing period. At this point, the protection period begins and runs to the expiration of the caplet. The protection period is usually three