I’m getting confused over something that should be so simple - perhaps it’s too much staring at the books!
A Cap pays out if a reference rate (LIBOR) is above the strike rate e.g. Libor is 8%, strike 6%, the cap writer would pay the buyer 2%. A Floor pays if Libor
Q1 - So in essence a Cap is like a call…and Floor like a put payoff diagram?
Q2 - If my understanding of 1 is correct then a collar should be a long cap (long call) at strike of 4%, and a short floor (short put) at a strike of say 8%? But i’m seeing the Schweser notes has it as long cap short floor but the cap at a higher strike would that not make the payoff flat between the strikes instead of a slope?
In number 1 above you said Libor is 8%, strike 6%, so cap pays +2%. If the floor has a strike of 4%, then going long the cap and short the floor would be the right collar. If LIBOR is 8%, the cap pays off, and the floor is worthless. If LIBOR is 2% the cap is worthless, but the floor is in the money, and you have to pay the other guy 2% (floor strike is 4%).
A short collar is the reverse, short cap long floor.
If you buy both cap and floor, then you have a long straddle.
I think Dreary is spot on . You can also look at this as a equity options , a collar is a strategy if you think the rates are going to be in the range of 4 - 8 % lets say on the expiry the interest rate is 7% you would lose the option premium on long cap but gain the option premium on short floor .
would that not make the payoff flat between the strikes instead of a slope?