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] [
)] 0 , [max( ) , 0 (
,
Caps and Floors
A cap is a portfolio of call options on LIBOR. It has the
effect of guaranteeing that the interest rate in each of a
number of future periods will not rise above a certain
level
Payoff at time t
k+1
is Lo
k
max(R
k
R
K
, 0) where L is the
principal, o
k
=t
k+1
t
k
, R
K
is the cap rate, and R
k
is the
rate at time t
k
for the period between t
k
and t
k+1
A floor is similarly a portfolio of put options on LIBOR.
Payoff at time t
k+1
is
Lo
k
max(R
K
R
k
, 0)
Options, Futures, and Other Derivatives, 9th Edition,
Copyright John C. Hull 2014
9
Caplets
A cap is a portfolio of caplets
Each caplet is a call option on a future
LIBOR rate with the payoff occurring in
arrears
When using Blacks model we assume that
the interest rate underlying each caplet is
lognormal
Options, Futures, and Other Derivatives, 9th Edition,
Copyright John C. Hull 2014
10
Blacks Model for Caps (p. 680)
The value of a caplet, for period (t
k
, t
k+1
) is
The value of a floorlet is
Options, Futures, and Other Derivatives, 9th Edition,
Copyright John C. Hull 2014
11
F
k
: forward interest rate
for (t
k
, t
k+1
)
o
k
: forward rate volatility
L: principal
R
K
: cap rate
- o
k
=t
k+1
-t
k
- = and where
k
k k
k k K k
K k k k
t d d
t
t R F
d
d N R d N F t P L
o
o
o +
=
o
+
1 2
2
1
2 1 1
2 / ) / ln(
)] ( ) ( )[ , 0 (
| | ) ( ) ( ) , 0 (
1 2 1
d N F d N R t P L
k K k k
o
+
Blacks Model continued
When LIBOR discounting is used, the same
LIBOR/swap term structure is used to
calculate F
k
and P(0,t
k+1
)
When OIS discounting is used we calculate
the OIS zero curve first and then calculate the
LIBOR/swap zero curve that makes swaps
currently traded have zero value
The LIBOR/swap zero curve is used for F
k
and the OIS curve is used for P(0,t
k+1
)
Options, Futures, and Other Derivatives, 9th Edition,
Copyright John C. Hull 2014
12
When Applying Blacks Model
To Caps We Must ...
EITHER
Use spot volatilities
Volatility different for each caplet
OR
Use flat volatilities
Volatility same for each caplet within a
particular cap but varies according to life of cap
Options, Futures, and Other Derivatives, 9th Edition,
Copyright John C. Hull 2014
13
Theoretical J ustification for Cap
Model
model s Black' to leads This
Also
is price option the
time at maturing bond coupon - zero
a wrt FRN is that world a in Working
k k k
K k k k
k
F R E
R R E t P
t
=
+
+ +
+
] [
)] 0 , [max( ) , 0 (
1
1 1
1
Options, Futures, and Other Derivatives, 9th Edition,
Copyright John C. Hull 2014
14
Swaptions
A swaption or swap option gives the holder
the right to enter into an interest rate swap in
the future
Two kinds
The right to pay a specified fixed rate and receive
LIBOR
The right to receive a specified fixed rate and pay
LIBOR
Options, Futures, and Other Derivatives, 9th Edition,
Copyright John C. Hull 2014
15
Blacks Model for European
Swaptions
When valuing European swap options it is usual to
assume that the swap rate is lognormal
Consider a swaption which gives the right to pay s
K
on an n -year swap starting at time T. The payoff on
each swap payment date is
where L is principal, m is payment frequency and s
T
is market swap rate at time T
Options, Futures, and Other Derivatives, 9th Edition,
Copyright John C. Hull 2014
16
) 0 , max(
K T
s s
m
L
=
=
mn
i
i
t P
m
A
1
) , 0 (
1
T d d
T
T s s
d
K
o =
o
o +
=
1 2
2
0
1
;
2 / ) / ln(
where
Blacks Model continued
When LIBOR discounting is used, the same
LIBOR/swap term structure is used to
calculate s
0
and P(0,t
k+1
)
When OIS discounting is used we calculate
the OIS zero curve first and then calculate the
LIBOR/swap zero curve that makes swaps
currently traded have zero value
The LIBOR/swap zero curve is used for s
0
and the OIS curve is used for A
Options, Futures, and Other Derivatives, 9th Edition,
Copyright John C. Hull 2014
18
Theoretical J ustification for Swap
Option Model
model s Black' to leads This
Also
is price option the
swap, the underlying annuity the
wrt FRN is that world a in Working
0
] [
)] 0 , [max(
s s E
s s LAE
T A
K T A
=