Online Finance – Interest Rate Options – Pricing Caps & Floors

Caps and Floors

The most commonly used options in the swaps market are caps and floors. A cap is a call on the rates where the payoff depends on Max (LIBOR – Strike, 0). A floor is a put on the rates where the payoff depends on Max (Strike-LIBOR, 0).

Cap

A cap may be considered as a portfolio of caplets on the underlying asset which is the LIBOR. The value of the caplet may be derived using Black’s Formula. The value of a caplet which resets at time t_i and payoffs at time t_i+1 is:

Where  is known as the forward premium, X is the Strike, F_i is the forward rate.
[ad#Grey med rectangle]

This is illustrated below for a 4 year cap on a 1 year Inter-bank offer rate with a strike of 12.5%. The annualized constant volatility is 3.13%. The valuation date is 31/5/2010 and the payment frequency is annual. The notional amount is 100,000.

Period Start (i)	Period End (i+1)	ti	ti+1	ZCti+1	Fi	d1	d2	Forward Premium	Value of Caplet
01/01/10	01/01/11	n/a	0.59	12.150%	12.150%	n/a	n/a	-	-
01/01/11	01/01/12	0.59	1.59	12.225%	12.269%	-0.76	-0.79	37.26	31.02
01/01/12	01/01/13	1.59	2.59	12.349%	12.583%	0.19	0.15	241.75	178.77
01/01/13	01/01/14	2.59	3.59	12.418%	12.595%	0.18	0.12	302.29	198.53
								Price of Cap	408.33

The calculation of d₁ and d₂ are based on the duration at the start of the period, i.e. t_i. Therefore for the first row we see that these values cannot be calculated. The forward premium in this case is simply equal to the payoff i.e. Max(F_i-X,0)*Notional*?t/365=max(12.15%-12.5%,0)*100000*0.59=0

For the other rows as d₁ and d₂ can be calculated the Forward Premium from Black’s formula will be used.

The price of the cap is the sum of the values of the caplets, which are the present values of the forward premiums.

Floor

A floor may be considered as a portfolio of floorlets on the underlying asset which is the LIBOR. The value of the floorlet may be derived using Black’s Formula. The value of a caplet which resets at time t_i and payoffs at time t_i+1 is:

Where  is the forward premium. d₁ and d₂ are as given above. The value of a 4 year floor with strike, volatility, notional, maturity and payment frequency the same as for the cap above is illustrated below:

Period Start (i)	Period End (i+1)	ti	ti+1	ZCti+1	Fi
01/01/2010	01/01/2011	n/a	0.59	12.150%	12.150%
01/01/2011	01/01/2012	0.59	1.59	12.225%	12.269%
01/01/2012	01/01/2013	1.59	2.59	12.349%	12.583%
01/01/2013	01/01/2014	2.59	3.59	12.418%	12.595%

d1	d2	Forward Premium	Value of Floorlet
n/a	n/a	206.16	192.70
-0.76	- 0.79	268.02	223.14
0.19	0.15	158.39	117.12
0.18	0.12	207.47	136.26
		Price of Floor	669.22

Again it may be noted that the calculation of d₁ and d₂ are based on the duration at the start of the period, i.e. t_i. Therefore for the first row we see that these values cannot be calculated. The forward premium in this case is simply equal to the payoff i.e. Max(X-F_i,0) * Notional * ?t/365 = max(12.5%-12.15%,0)*100000*0.59=206.16

For the other rows as d₁ and d₂ can be calculated the Forward Premium from Black’s formula will be used.

The price of the floor is the sum of the values of the floorlets, which are the present values of the forward premiums.

For a formula reference, please see the following link

Black Formula an pricing Interest Rate Caps and Floors – Calculation reference