huangxiaoxie

Hey guys--due to being short on time I've only skimmed the responses above, but taking a second look at the Q I now believe this is the rationale. Please let me know if this makes sense.


You are told that you are long cap and short call. This implies that you are short the floating rate bond. Why? If you are short the floating rate bond (automatically think interest rates), you want rates to go down. Thus, you fear rates going up and buy protection if rates go up. That protection is a cap. So long cap/short call for a zero collar position.

Now that you know you are short the floating rate bond, pretend the cap and floor rate are both 10%.

If rates go to 13%, you recieve 13%-10% = +3% on your cap. But you have to pay 13% on your floating rate bond, so you have a loss equal to -3%. So net-net you are paying 10%.

If rates go to 8%, you recieve nothing on your cap. But you sold a floor, so you have to pay 10% - 12% = -2%. But you get to pay only 8% on your floating rate bond. So gain of +2%. So net-net you are paying 10% on your floating rate bond.

In summary, being short a floating rate bond coupled with a long cap/short put collar means that you are essentially paying a fixed rate.