Hey guys, am still somewhat confused as to what instruments requirement the payment in arrears (i.e. those that reference the current LIBOR for a payment in the future). 1. Other than interest rate caps and floors, interest rate swaps, are there any others that require payment in arrears? 2. Do interest rate call/put options have payment in arrears? Am confused on this point becos interest rate caps and floors are essentially series of calls and puts, but it appears that when we use interest rate call/put options, the payment is referenced based on the current LIBOR at the time of the payment
my comment from level II, hope it helps: the simple interest rate call/put (sometimes called interest rate guarantee IRG) is settled as FRA, two days after fixing date (expiry date) - discounted interest difference. interest rate cap and floor is settled as IRS, the interest difference is settled at the end of relevant interest rate period. it is common pratice the interest is supposed to be paid at the end of the interest rate period, that is how the interest rates are quoted. therefore if you want to move payment backwards you need to discount it, always. (for instance FRA) FRA and IRG are settled upfront because they have just one interest rate period, you (as buyer) dont need to wait for settlement next couple of months. it decreases possible credit risk.
So based on your explanation, interest rate call/put options reference the current LIBOR rate that occurs at the point of settlement while interest caps/floors reference the beginning of period LIBOR rate, am I correct?
the good thing about payments in arrears, they are USUALLY used for caps/floors/collars (acc. to the curriculum) wich means they must STATE it in the text if the instrument will be paid so If yes, simply calc the payoffs @t with the rates from t-1
Good point.
The way I think of this confusing topic is - an option (call or put) gives you the right to a cash flow at the end of the option expiration, and you will exercise if the interest rate is in your favor at option expiration (or earlier also?). There is no “arrears” here - the day you exercise option gives you the interest rate from that day. Caps and Floors are also like options - payment only happens if they in your favor, but the interest rate used to determine payoff is from beginning of settlement period. Interest Rate swaps - they are not options, there has to be a payoff to either party, but the payoff is determined at the beginning of the period and hence interest rate is from beginning of settlement period. Please correct me if I am wrong here.