What is an interest rate cap?

An interest rate cap is a financial derivative that provides protection against rising interest rates by specifying a maximum rate, known as the ceiling, that a borrower will pay on their variable-rate debt. If the interest rate exceeds this ceiling, the cap pays the difference to the borrower. This hedging mechanism ensures that the borrower is not adversely affected when market interest rates rise significantly, thus managing their interest rate risk.

This definition aligns directly with the correct answer, which states that an interest rate cap offers payments when a specified interest rate index surpasses a predetermined ceiling. It is a crucial tool for borrowers who want certainty regarding their interest expenses while still taking advantage of lower interest rates when they fall below the ceiling level.

Other options, although they reference various financial agreements, do not correctly represent the function of an interest rate cap. For example, one option suggests payments when interest rates fall, which pertains instead to interest rate floors. Another focuses on protecting against currency exchange rate fluctuations, which is related to currency hedging, not interest rate management. Lastly, swapping interest rates with another party describes an interest rate swap, a different financial instrument altogether. Thus, the essence of an interest rate cap is encapsulated accurately by the chosen answer.