X +(-) S1 but at the same time shorts a floor (cap) for a strike of X +(-) S2 so that the premium of one at least partially offsets the premium of the other. Here S1 is the maximum tolerable unfavorable change in payable interest rate and S2 is the maximum benefit of a favorable move in interest rates. Example Consider an investor who has an obligation to pay floating 6 month LIBOR annually on a notional N and which (when invested) earns 6%. A rise in LIBOR above 6% will hurt said investor, while a drop will benefit him. Thus, it is desirable for him to purchase an interest rate cap which will pay him back in the case that the LIBOR rises above his level of comfort. Figuring that he is comfortable paying up to 7%, he buys an interest rate cap contract from a counterparty, where the counterparty will pay him the difference between the 6 month LIBOR and 7% when the LIBOR exceeds 7% for a premium of 0.08N. To offset this premium, he also sells an interest rate floor contract to a counterparty, where he will have to pay the difference between the 6 month LIBOR and 5% when the LIBOR falls below 5%. For this he receives a 0.075N premium, thus offsetting what he paid for the cap contract. Now, he can face 3 scenarios: Rising interest rates - he will pay a maximum of 7% on his original obligation. Anything over and above that will be offset by the payments he will receive under the cap agreement. Hence, the investor is not exposed to interest rate increases exceeding 1%. Stationary interest rates - neither contract triggers, nothing happens Falling interest rates - he will benefit from a fall in interest rates down to 5%. If they fall further, the investor will have to pay the difference under the floor agreement, while of course saving the same amount on the original obligation. Hence, the investor is not exposed to interest falls exceeding 1%. Rationale In times of high volatility, or in bear markets, it can be useful to limit the downside risk to a portfolio. One obvious way to do this is to sell the stock. In the above example, if an investor just sold the stock, the investor would get $5. This may be fine, but it poses additional questions. Does the investor