Easy Way to Think about Caps, Floors, Swaptions

Anyone have an easy way to think about this stuff?

for Caps/Floors - 1 cap means buying a series of call options. e.g. one 2-year interest rate cap, its value = one 1-year interest rate call, plus one 2-year interest rate call. think it as you’re standing on time 0, you buy 2 call options for year 1 and year 2 that’s the same as a interest rate cap, which offers you the same protection.

i am really having trouble understanding why a 2 year cap equals = one 1-year interest rate call, plus one 2-year interest rate call. where are the payoffs and why is it a 1 year interest call and again a 2 year interest call? because payoff for the cap is actually at year 3?? ahhhh! thank you

You have two years to cover 1 Year Call - Covers from 0—1 2 Year Call - Covers from 0—1---2 Thus, you are “protected” for 2 years based on the current rates.

§ayor Swaption = §ut Option Swaption rate is always the Fixed Rate so: §ayor Swaption is alway an option to §ay fixed rate. Just remember to match up the P’s Receiver Swaption is just the opposite, if you geta Q on Receiver Swaption - figure out what a Payor Swaption would be and the Receiver does the opposite. ie. Q asks what a Receiver Swaption is, then think: “Ok, a payor swaption is a put, so a receiver is a call - alway use fixed rate so receiver is a call on the fxed rate!”

I know a payer = put. BUT Logically if i BUY a payer swaption (an option to pay fixed) i want the fixed rate to be LOW. So if rates rise from a 3% strike to 5% at expiration, I would benefit by paying only 3% fixed when the markets call for 5% fixed. Wouldn’t that mean its like a call? i profit when rates rise = call. If I BUY a receiver swaption to receive fixed, I want rates to fall so I get the higher fixed rate and only have to pay the lower floating. I know i have this backwards. Does that mean I should think about this as options on BONDS and not RATES???

Remember being long any option gives a right to excercise , never an obligation.

FinNinja, I think you have it exactly backwards. A payer swaption is in the money if swap rates RISE. Makes sense, cause you pay less than the market rate thanks to your option. A receiver swaption is in the money if swap rates FALL. Also makes sense, cause you want to RECEIVE more than the market rate. besides which, I’m not sure that the put and call terminology applies very well with swaptions. Have you seen a question that used it? just think payer / receiver and caps and floors: same thing. You want to cap the amounts that you are on the hook for. and you also want a floor under the amounts that you will get.

from the point of view of a bond, not interest rates - FinNinja is right… Put option on a Fixed Income Bond = Payer Swaption.

To elaborate on cpk Interest rate call option = Put option on fixed income instrument (both benefit from rise in interest rates) Interest rate put option = Call option on fixed income instrument (both benefit from fall in interest rates)

sorry, i still have trouble. so a one year put equals a one year floor. and a 2 year put . equals a one year floor plus a two year floor. when are the pay offs i just dont seem to understand the logic behind this! :frowning:

I’m not sure If I have seen a Q on this or not. However, it does specifically mention in the book that the payor is a put and a receiver is a call so that is why I memorized these in this respect. I figure if it’s in the book, it’s pretty much fair game for the test.

As I understand now payer swaption = put on BONDS. PUT on bonds - you want bond value to fall for the put to be in the money. Bond values fall when rates go UP. You want rates to go UP to “win”. Payer Swaption - pay fixed rate is the strike (set at initiation), so you want rates to rise over strike meaning you are paying this fixed amount that is lower than the fixed amount that fools in the market have to pay. In both cases you WIN if rates go UP. Flip it and you can see why receiver swaption = call on BONDS.