March mock says: a combination of the purchase of an interest rate call option and the sale of an interest rate put option is equivalent to a plain vanilla interest rate swap payment. Long interest rate call: gain when interest rates increase Short interest rate put: gain when interest rates increase We are trying to mimic the receiver swap, but long call and short put only gains when interest rates increase. Can someone explain this please.
Fixed that for you.
Sorry this is still unclear. When they say we need to mimic the gains and mimic the losses, do they mean we need something that gains with increase in I.R and loses with decrease in I.R? In that case, we only gain when I.R increases?
Yes, we’re trying to duplicate the gains and losses on a plain vanilla interest rate swap.
Long interest rate call options gain when the floating rate is above the strike rate, and expire worthless when the floating rate is below the strike rate. Short interest rate put options lose then the floating rate is below the strike rate and expire worthless when the floating rate is above the strike rate. Thus, a combination of a long interest rate call and a short interest rate put will gain when the floating rate is above the strike rate (long call) and lose when the floating rate is below the strike rate (short put); this is exactly what happens to the long position (pay fixed, receive floating) in a plain vanilla interest rate swap, when the strike rate on the options equals the price of the swap.
Got it now, great thanks
You’re quite welcome.