Which of the following is equivalent to a pay-fixed interest rate swap? A) Buying a cap and selling an interest rate collar. B) Selling a cap and buying a floor. C) Buying a cap and selling a floor.
C
C
C is correct. Can you please explain a bit?
in pay fixed rate, you get benefit when floating rate goes up and lose when rates go down. Same thing with Buy Cap - you get the benefits when rates go up and lose when down
think about the payoffs. if you’re paying fixed, you make money when interest rates go up (you still pay fixed, but get a higher floating rate). what pays off like that? a LONG cap. if interest rates go down, in a pay fixed, you’d lose money. if you sell a floor, the payoff diagram is going to be just that- where you lose money and have to pay out as the interest rate starts falling below that floor. this would (i believe) assume here you’d buy the cap and sell the floor same strike, cost and credit would offset each other. but mostly think of the payoffs of each one individually and you should get these sorts of q’s right.
cfaboston28 and bannisja, thanks!