Easy Way to Think about Caps, Floors, Swaptions about

noel

Anyone have an easy way to think about this stuff?

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.

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.

5566

(P)ayor Swaption = (P)ut Option

Swaption rate is always the Fixed Rate so:

(P)ayor Swaption is alway an option to (P)ay fixed rate.

Just remember to match up the P's

Receiver Swaption is just the opposite, if you geta Q on Receiver Swaption - figure out what a Payor Swaption would be and the Receiver does the opposite.

ie. Q asks what a Receiver Swaption is, then think:
"Ok, a payor swaption is a put, so a receiver is a call - alway use fixed rate so receiver is a call on the fxed rate!"

Newhuman

I know a payer = put.

BUT

Logically if i BUY a payer swaption (an option to pay fixed) i want the fixed rate to be LOW. So if rates rise from a 3% strike to 5% at expiration, I would benefit by paying only 3% fixed when the markets call for 5% fixed. Wouldn't that mean its like a call? i profit when rates rise = call.

If I BUY a receiver swaption to receive fixed, I want rates to fall so I get the higher fixed rate and only have to pay the lower floating.

I know i have this backwards. Does that mean I should think about this as options on BONDS and not RATES?????

BelalM

Remember being long any option gives a right to excercise , never an obligation.

spreads

FinNinja, I think you have it exactly backwards.

A payer swaption is in the money if swap rates RISE. Makes sense, cause you pay less than the market rate thanks to your option.

A receiver swaption is in the money if swap rates FALL. Also makes sense, cause you want to RECEIVE more than the market rate.

besides which, I'm not sure that the put and call terminology applies very well with swaptions. Have you seen a question that used it?

just think payer / receiver

and caps and floors: same thing. You want to cap the amounts that you are on the hook for.
and you also want a floor under the amounts that you will get.

eoin

from the point of view of a bond, not interest rates - FinNinja is right...

Put option on a Fixed Income Bond = Payer Swaption.

CP

thecfawannabe

To elaborate on cpk

Interest rate call option = Put option on fixed income instrument (both benefit from rise in interest rates)

Interest rate put option = Call option on fixed income instrument (both benefit from fall in interest rates)