Interest Rate Options and FRAs
For interest rate options, the exercise price is an interest rate, and payoffs depend on a reference rate such as LIBOR.
The combination of a long interest rate call option plus a short interest rate put option has the same payoff as an FRA.
Long interest rate call + short interest rate put = FRA
Interest Rate Option
Payoff is made
After the option expiration
A long interest rate call and a short interest rate put is an equivalent position to:
A. a long position in a forward rate agreement.
B. a pay-fixed interest rate swap.
C. a short position in a forward rate agreement.
The answer is A. A long call and short put on interest rates is equivalent to a long position in a forward rate agreement. Both gain when forward rates increase and decline in value when interest rates decrease.
Define interest rate caps, floors, and collars.
Interest Rate Caps, Floors and Collars
A caplet is a European call option on interest rates. An interest rate cap is a combination of caplets, with each caplet having the same strike rate (cap rate).
A floorlet is a European put option on interest rates. An interest rate floor is a combination of floorlets, with each floorlet having the same strike rate (floor rate).
An interest rate collar is a combination of a long (short) cap and a short (long) floor on the same underlying rate with the same expiring dates.
Floating-rate loan borrowers can long a cap and short a floor to hedge the risk of interest rates.
The value of a cap or a floor is just the sum of the values of the individual caplets or floorlets.
Caps and floors pay in arrears.
An investor who bought a floating-rate security and wishes to establish a minimum periodic cash flow on his investment could:
A. buy an interest-rate floor.
B. sell an interest-rate floor.
C. sell an interest-rate cap.
The buyer of a floor will receive a payment when the floating rate is below the floor rate, effectively establishing a minimum rate on the floating rate security.
Buying an interest-rate cap and selling an interest-rate floor is equivalent to:
A. buying a series of interest-rate puts and selling a series of interest rate calls.
B. buying a series of interest-rate calls and selling a series of interest-rate puts.
C. buying a series of interest-rate puts and calls.
A cap is equivalent to a series of (long) interest-rate calls and selling a floor is equivalent to selling a series of interest-rate puts.