Interest Rate Derivative

Summaries

1. Interest rate cap
1. Buyers pay premium to sellers
2. Sellers pay buyers if the rate is higher than the striking rate (cap rate)
3. Equivalent to a series of interest rate call options (caplets)
4. Long cap is equivalent to long put in fixed income securities
5. Pay off: max(0, (rate – cap rate)x amount x day/360)

2. Interest rate floor
1. Buyers pay premium to sellers
2. Sellers pay buyers if the rate is lower than the striking rate (floor rate)
3. Equivalent to a series of put options on interest rate (floorlets)
4. Long floor is equivalent to long call in fix income securities
5. Pay off: max(0, (floor rate –rate)xamount x day/360)

3. Pay off is arrear! So, it is the value at the end of the period. E.g. LIBOR 3 months spot rate is 6%, the payoff is the amount to receive after 3 months. Therefore, to calculate the value of the cap and floor, have to discount to current value!

4. Collars
1. Cap+Floor on the same benchmark rate, periods and settlement dates
2. If have LIBOR based liability: Long Cap + Short Floor (earn premium by selling floor to cover cost of buying cap)
3. If have LIBOR based asset : Short Cap + Long Floor