1.Can you please explain how can we replicate swaps by using options ??
2.This question’s solution doesn’t make much sense to me,can anybody explain please ?
A cap on a floating rate note, from the bondholder’s perspective, is equivalent to:
A) writing a series of puts on fixed income securities. B) owning a series of calls on fixed income securities. C) writing a series of interest rate puts.
The correct answer was A.
For a bondholder, a cap, which puts a maximum on floating rate interest payments, is equivalent to writing a series of puts on fixed income securities. These would require the buyer to pay when rates rise and bond prices fall, negating interest rate increases above the cap rate. Writing a series of interest rate calls, not puts, would be an equivalent strategy. Calls on fixed income securities would pay when rates decrease, not when they increase.
from a floating rate note bondholder’s perspective, you profit when interest rates rise. If there is a cap on a the floating rate, you have lost any upside, above a certain interest rate level.
An equivalent situation is if you were to write put options on bonds. As bond prices trade inversely to interest rates. In this case, as interest rates rise bond prices fall and as interest rates rise above a certain level bond price will fall far enough that the put option becomes in the money. As the writer of the option, you will need to settle this out of your pocket.
Great and tricky question, and thanks for the clear answer. I’m now confused though. Why does it say on the CFAI the following (p.324): “Buying a cap (long cap) is equivalent to buying a package of puts on a fixed-income instrument”
Is this definition from the issuer’s perspective then? So the bondholder’s perpective, as in the OP, would be the exact opposite?
The cap is a series of caplets, so it’s like a strip of puts with different maturity dates.
If rates go up and beyond the cap rate, the caplet pays the buyer of the cap a payoff. Equally, if the same guy had bought puts, if rates go up, bond prices will fall and give the buyer of the puts a payoff if the bond price is below the strike of each put at each puts maturity.
This question has nothing to do with swaps and it apears to me a schwser question (confirmation needed).
Cap is a series of call option on interest rate “not on the bond” and this question clearly states cap on the floating rate note (rather interest rate cap). Recall from level 1, debt securities have embedded options like caps and floors. This question compares embedded options with stand alone option (Puts)
Bondholder will loose money if market interest rates rise above cap, bond will be trading at discount.
If someone writes/sells Put options on bond (not on the interest rates) he will loose money if interest rates rise. Increase in the interest rate will lower the bond price making put option in the money and put option holder will exercise the option and the one who wrote the put option would be holding a bond just like bondholder having cap on floating rate note.
@Lili_ : "Buying a cap (long cap) is equivalent to buying a package of puts on a fixed-income instrument”
Here cap means series of interest rat call options. In cap underlying is interest rate and Puts on fixed income instrument where underlying is debt security.
In that statement two different underlyings are being compared interst rate and debt security. You make money on cap when market rates rise and you make money in the puts on debt security when market rates rise bond trades at discount and you exercise the put options and sell bond at higher price.