Hi Guys,
When we come up with the value of a call option on stock (given two period model), we just calculate in a reverse direction and get the call option price.
When it comes to valuing a Cap - you add 2year caplet and 1year caplet. So the calculation for a two year caplet is similar to stocks above (except for the probalities)… Why do we again add the one year caplet to two year caplet to get the value of the CAP.
Am i missing something here conceptually?
Please advise.thanks.
Howdy.
Because a cap comprises a set of options (caplets): a 1-year option, a 2-year option, and so on. Each option is discounted to today to get its present value, then they’re added to get the total present value of the entire set: the cap.
Not any longer.
You’re welcome.
ok so you mean on stocks, we just have a single option vs the cap where we have a set of options, that’s why the difference… if that’s the case, then i got it…thanks buddy…
Well, then . . . you got it!
In a cap, you have an option for each payment date. For example, if you have a 30-year, monthly, floating-rate mortgage with a cap, you have 360 separate options (caplets): one that expires in 1 month, one that expires in 2 months, . . . one that expires in 159 months, and one that expires in 360 months.
My pleasure.