Description:-
Unlike a call or put option, a cap has multiple potential payoffs determined by a settlement frequency and a maturity. At each settlement date, if the underlying index is below the strike rate, no payments are exchanged (aside from the premium). If the underlying index exceeds the strike rate, the seller of the cap must pay: (Index Rate – Strike Rate) X (Days in settlement period/360) X Notional Amount
Cap/Floor Terminology
Strike rate is the rate which determines any cash flows of the cap or floor. Similar to the strike price or exercise price.
Underlying index is the interest rate that we want protection for or are speculating on.
Notional amount is the principal to which the interest rate will be applied to determine payoffs.
Up-front premium is the amount the buyer must pay to own the cap/floor.
An Example of a Cap
A borrower has issued a floating rate note and is paying LIBOR quarterly over the next three years. By purchasing a cap with a 10% strike rate, quarterly settlement frequency, a maturity of three years, and a notional amount equal to the amount of the note, the borrower can hedge its exposure to increasing LIBOR.
Why are they traded?
Cap or floor can be traded to manage the financial risk for insurers. Example – Defined benefit pensions assume that contributions will earn an amount which will provide benefits in the future.
If the return on the assets is below the assumed return, the benefits are at risk . Pension fund can buy a floor so that in periods of low returns, they will receive payments from the floor option.
Life cycle events: –
Premium and pay off’s.
OTCWIRE 