lucasg85

i am really having trouble understanding why a 2 year cap equals =
one 1-year interest rate call, plus
one 2-year interest rate call.

where are the payoffs and why is it a 1 year interest call and again a 2 year interest call?
because payoff for the cap is actually at year 3?? ahhhh! thank you

smuggycfa

You have two years to cover

1 Year Call - Covers from 0---1
2 Year Call - Covers from 0---1---2

Thus, you are "protected" for 2 years based on the current rates.

genuinecfa

for Caps/Floors - 1 cap means buying a series of call options.

e.g.

one 2-year interest rate cap, its value =
one 1-year interest rate call, plus
one 2-year interest rate call.

think it as you're standing on time 0, you buy 2 call options for year 1 and year 2
that's the same as a interest rate cap, which offers you the same protection.