Valuing Caps and Floors w/ Binomial Model

svgleeson

So the math makes sense, but the concept does not. Referring to Schweser pages 72 - 73, why for a two-year cap would you discount it three times? Is this because it pays in arrears?

For example, with a 3 year bond, you discount it 3 times to get back to present (from year 3 to 2, year 2 to 1, and year 1 to present).

With a two year cap, you discount it the same way as a 3-year bond. I would think 2-years would cover you from year 0 to 1, and then year 1 to 2, with no coverage from year 2 to 3.

Any clarification appreciated!

WarrenB1

the reason why you discount an additional term is cause the option to exercise on a caplet occurs at expiry; so if you exercise at expiry, that means your expected payoff occurs at expiry + 1. so you discount that value back to 0, which will include 1 extra year

similar to an FRA

I think!!