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3 Cards in this Set

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How are caps and floors the same as a series of calls or puts on interest rates?




pg 128-130, derivs

First start with what an interest rate cap is. The buyer of an interest rate cap will get paid every time the interest rate fluctuates above a "cap rate". This means that the pay schedule on being long an interest rate cap is the same as being long a call option on that rate.




The same is true for being long a floor. The holder of a long interest rate floor position will get paid when the rates go below a certain "floor rate". This means that the pay schedule is identical to being long an interest rate put.




One important thing to consider is if the investor is buying derivatives on the bonds rather than the rates. Because of the inverse relationship between bond prices and rates, as rates increase, bond prices decrease. This means that the holder of a cap on the bond prices would benefit from a decrease in rates (put pay schedule), and a holder of a floor would benefit from an increase in rates (call pay schedule).

Be able to calculate the payoffs for interest rate caps and floors. This is not difficult if you think conceptually about what a cap and floor is.




examples on page 131-132

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