short question on collars buying, equivalent, following, question

towardsutopia21

Which of the following is equivalent to a pay-fixed interest rate swap?
A) Buying a cap and selling an interest rate collar.
B) Selling a cap and buying a floor.
C) Buying a cap and selling a floor.
Your answer: A was incorrect. The correct answer was C) Buying a cap and selling a floor.
A pay-fixed interest rate swap has the same payoffs as a long position in the corresponding interest rate collar (with the strike rate equal to the swap fixed rate).
here is my question…if cap and floor rates are the same, i see how you replicate the fixed payments…but in a pay fixed swap, you are also receiving floating rate payments…how is that replicated by buying a cap and selling a floor?
for example, say cap and floor rates are 5%. if rates go above 5%, you will always pay 5% due to the cap. if rates go below 5%, you will still pay 5% do to the floor. waht about the floating rate receipts? seems like buying a cap and selling a floor of the same strike rate only replicates a fixed rate bond.

bdavi77962

Let’s see:
The swap settles a floating rate against a fixed rate, and the net interest generates a cash flow 1 period later.
If floating rate rises beyond the swap fixed rate , the pay-fixed receives a payment
The cap buyer receives a payment whenever the floating rate exceeds the strike ( which is same as swap fixed rate ). That is the meaning of cap , after all , the buyer is paid when floating exceeds collar strike .So swap is same as cap for rates above the strike .
Next when rates drop below strike , the swap fixed pays the swap floating the difference.
On the floor side , the seller of the floor who is nothing but same collar holder pays the counterparty the difference between the strike and the floating . That is after all the meaning of a floor ( seller pays buyer when rates fall below strike).
So the floor cash flow is same as the swap cash flow.
Therefore with one instrument i.e. a swap , we are replicating a buy-cap/sell-floor deal, i.e. we are replicating a collar

Dapper425

1) The pay-fixed leg of an interest rate swap is long on rate;
2) cap is call on rate; floor is put on rate. (caplets/floorlets)
So the answer is C).
This is similar: long stock == buy call + sell put.

stalkey

A pay fixed rec floating swap has negative duration, so it benefits when rates increase. Among the choices given, only buy a cap and sell a floor will benefit from rates increase.

WarrenB1

ok got it. this is essentially what we learned in level 2 swaps material…that a pay fixed swap is equal to a long call and short put.
thank you guys.