I’m a little confused about the cap/floor payoff. I’m not sure when the payoff would occur arrear. In Schweser Practice Exam 1, problem 33 was asking to compute a 2 year interest rate floor payoff at the end of year 2. The reference rate is LIBOR. According to “Option Markets and Contracts” chapter, the cap/floor payoffs occur arrear, so the payoff should be discounted back a year. That’s what I did on the practice exam, but apparently that was wrong. Could someone please shed some light? Thanks!
Ok… I think I was confusing caplet/floorlet value with the actual payoff. Anyway I guess the bottom line is, correct me if I’m wrong, when valuing the options, we discount them back a year. When calculating the actual payoffs, we don’t apply any discount.