Insurance products are contingent claims. The insured party pays a premium for the contract (for example, an automobile policy). Should the specified condition (for example, an automobile accident) not occur, no payment is made under the policy. However, if the condition does take place, the insurer pays according to the contract’s terms. Caps and collars work exactly in this way. A borrower who wishes to limit its interest rate exposure pays a premium to the writer of the contract. Should interest rates remain below the cap or within the collar, no payment is made to the borrower. However, if rates move outside the specified limits, the writer of the contract reimburses the borrower, in this case by the amount of the interest payment resulting from the difference between the actual and contract rates.
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