Can someone explain to me when you use arrears when calculating interest rate cap and floor payouts? The examples in schweser confused me – the cap and floors use the same LIBOR rates as the current interest rate payments (LIBOR + bp). How is that arrears?

You use the beginning-of-period LIBOR, but payment occurs at the end of the period.

i see. but for an interest rate call or put you would use the end of period LIBOR value. is that correct?

Correct …usually they dont give u mutliple period rates when you calculate calls/puts

^^^ I think even the options payouts are made at the end of the period…i.e., the determine the payouts(if any) based on the prevailing rates and the strike rate at the beginning and the payments are actually made at the end. Otherwise it will not be a proper hedge. Correct me if I am wrong.

To my knowledge, interest rate caps and floors and swaps use the rate from the prior period and the # of days in the current period to determine the payout, if any.