Chapter 4: Interest Rate Derivatives

4.2 Caps and Floors

Interest Rate Models

Damir Filipovic
4.2 Caps and Floors

Caps protect against high rates

Floors protect against low rates
Cap-Floor parity
Pricing under forward measures
Blacks price formula
Bacheliers price formula
Cap/Floor quotes in terms of implied
volatilities

Interest Rate Models

Caplets

A caplet with reset date T0 and

settlement date T1 = T0 + pays the
holder the difference between simple
spot rate L(T0 , T1 ) and strike rate .

The cash flow at T1 is

t T0 T1
(L(T0 , T1 ) )+ .

Protects against rising interest rates.

Interest Rate Models

Price of Caplet

The time-T0 value of the caplet is

P(T0 , T1 )(L(T0 , T1 ) )+
1

+
= (1 + ) 1+
P(T0 , T1 )

(1 + ) put option on T1 -bond with

1
expiry date T0 and strike price 1+ . t T0 T1
Time-t price of the caplet therefore is

Cpl(t, T0 , T1 ) = (1 + ) pput .

Interest Rate Models

Caps

A cap is a strip of caplets, specified by

reset/settlement dates T0 < < Tn
(T0 =first reset date, Tn =maturity)
a cap rate
for simplicity assume: Ti Ti1
t T0 T1 Tn1 Tn
The cap price at t T0 is

Cp(t) = ni=1 Cpl(t, Ti1 , Ti )

P

with price of ith caplet Cpl(t, Ti1 , Ti ).

Interest Rate Models

Floors

A floor
is the converse to a cap,
protects against low interest rates,
is a strip of floorlets with Ti -cash flows

( L(Ti1 , Ti ))+ .
t T0 T1 Tn1 Tn
The floor price at t T0 is

Fl(t) = ni=1 Fll(t, Ti1 , Ti )

P

with price of ith floorlet Fll(t, Ti1 , Ti ).

Interest Rate Models
Caps, Floors and Swaps

The following parity relation holds:

Cp(t) Fl(t) = Vp (t)

where Vp (t) is the time-t value of a payer swap with fixed rate , notional one,
and the same tenor structure T0 < < Tn as the cap and floor.

The cap (floor) is said to be

P(t,T
P 0 )P(t,Tn )
at-the-money (ATM) if = Rswap (t) = ni=1 P(t,Ti )
in-the-money (ITM) if < Rswap (t) (floor: > Rswap (t))
out-of-the-money (OTM) if > Rswap (t) (floor: < Rswap (t))

Interest Rate Models

Black's Formula: Underlying Assumptions

Blacks formula assumes that L(Ti1 , Ti ) = F (Ti1 , Ti1 , Ti ) is log-normal with

dF (t, Ti1 , Ti ) = F (t, Ti1 , Ti ) dW Ti (t)

with constant > 0 and Brownian motion W Ti (t) under the Ti -forward measure.

Time-t prices of ith caplet and floorlet are

Ti
(L(Ti1 , Ti ) )+
 
Cpl(t, Ti1 , Ti ) = P(t, Ti )EQ
t

Ti
( L(Ti1 , Ti ))+
 
Fll(t, Ti1 , Ti ) = P(t, Ti )EQ
t

Interest Rate Models

Black's Formula for Caplets and Floorlets

Blacks formula for the ith caplet and floorlet price is

Cpl(t, Ti1 , Ti ) = P(t, Ti ) (F (t, Ti1 , Ti )(d1 ) (d2 ))

Fll(t, Ti1 , Ti ) = P(t, Ti ) ((d2 ) F (t, Ti1 , Ti )(d1 ))

where is the standard normal cumulative distribution function and

h i
F (t;Ti1 ,Ti )
log
12 2 (Ti1 t)
d1,2 = p .
Ti1 t

: Black (or relative) volatility (same for all caplets/floorlets of a cap/floor).

Interest Rate Models

Bachelier's Formula: Underlying Assumptions

Bacheliers formula assumes that L(Ti1 , Ti ) = F (Ti1 , Ti1 , Ti ) is normal with

dF (t, Ti1 , Ti ) = dW Ti (t)

with constant > 0 and Brownian motion W Ti (t) under the Ti -forward measure.

Time-t prices of ith caplet and floorlet are

Ti
(L(Ti1 , Ti ) )+
 
Cpl(t, Ti1 , Ti ) = P(t, Ti )EQ
t

Ti
( L(Ti1 , Ti ))+
 
Fll(t, Ti1 , Ti ) = P(t, Ti )EQ
t

Interest Rate Models

Bachelier's Formula for Caplets and Floorlets

Bacheliers formula for the ith caplet and floorlet price is

p
Cpl(t, Ti1 , Ti ) = P(t, Ti ) Ti1 t (D(D) + (D))
p
Fll(t, Ti1 , Ti ) = P(t, Ti ) Ti1 t (D(D) + (D))

where is the standard normal cumulative distribution function, = 0 , and

F (t, Ti1 , Ti )
D= p .
Ti1 t

: normal (basis point, absolute) volatility (same for all caplets/floorlets of a

cap/floor).
Interest Rate Models
Cap and Floor Quotes

Cap/floor prices are quoted in terms of their Black or normal implied volatilities.

Typically: t = 0, T0 = = Ti Ti1 with

= three months (US market)
= half a year (euro market)

Interest Rate Models

Example of Cap Quotes

EUR ATM Cap Quotes, 30 August 2013:

100 100

Maturity(yrs) CapATMPrice(%) BlackATMVol(%) NormalATMVol(bps)

1 0.08% 93.81% 33.23 80 80
2 0.35% 90.31% 46.94

Normal ATM Vol (bps)

3 0.84% 65.94% 60.15

Black ATM Vol (%)

4 1.61% 58.65% 70.25 60 60
5 2.54% 53.14% 77.76
6 3.60% 49.12% 83.54
7 4.60% 45.59% 85.60 40 40
8 5.62% 42.17% 86.46
9 6.65% 39.59% 86.94
10 7.67% 37.04% 86.52 20 20
15 12.38% 30.86% 84.08
20 16.15% 28.70% 79.81
30 22.35% 27.39% 73.01
0 5 10 15 20 25 30
Maturity (yrs)

It is a challenge for any interest rate model to match the given volatility curve.
Interest Rate Models