An example of a cap would be an agreement to receive a payment for each month the LIBOR rate exceeds 2.5%.
An example of a cap would be an agreement to receive a payment for each month the LIBOR rate exceeds 2.5%.
[1] Since the strike price reflects the maximum interest rate payable by the purchaser of the cap, it is frequently a whole number integer, for example 5% or 7%.
[1] In mathematical terms, a caplet payoff on a rate L struck at K is where N is the notional value exchanged and
For example, suppose that it is January 2007 now and you own a caplet on the six month USD LIBOR rate with an expiry of 1 February 2007 struck at 2.5% with a notional of 1 million dollars.
The size of cap and floor premiums are impacted by a wide range of factors, as follows; the price calculation itself is performed by one of several approaches discussed below.
The simplest and most common valuation of interest rate caplets is via the Black model.
Many substitute methodologies have been proposed, including shifted log-normal, normal and Markov-Functional, though a new standard is yet to emerge.
[2] It can be shown that a cap on a LIBOR from t to T is equivalent to a multiple of a t-expiry put on a T-maturity bond.
The methodology for valuation of CMS Caps and Floors can be referenced in more advanced papers.