Are you sure?
This action might not be possible to undo. Are you sure you want to continue?
Caps and floors trade over the counter, and are tools that companies can use to manage interest rate exposure,
and that fixed income managers can use to make trading profits and manage their portfolio
A cap can be associated with any underlying interest rate. For the most part, they are linked to LIBOR.
A cap must specify a cap ratewhich is the strike price of the option, a notional principle, used to compute the cash flows, and
a tenor, which indicates the term of the rate as well as the frequency of resets and payments.
Example:
Cap on threemonth LIBOR with threemonth tenor
Notional Principal of $10 million
Cap Rate 4.78821%
Current Date 12/14/05
Valuation Date 12/16/05
Maturity: 12/16/10
This cap is shown on the Bloomberg screen.
The cash flows on this cap follow:
Date Reset Amt (R(T)) Cash flow
3/16/2006 (L(3)  X) P (dc)
+

6/16/2006 (L(3)  X) P (dc)
+
R(T1)
9/16/2006 (L(3)  X) P (dc)
+
R(T1)
12/16/2006 (L(3)  X) P (dc)
+
R(T1)
3/16/2007 (L(3)  X) P (dc)
+
R(T1)
6/16/2007 (L(3)  X) P (dc)
+
R(T1)
9/16/2007 (L(3)  X) P (dc)
+
R(T1)
12/16/2007 (L(3)  X)+ P (dc) R(T1)
3/16/2008 (L(3)  X)+ P (dc) R(T1)
6/16/2008 (L(3)  X) P (dc)
+
R(T1)
9/16/2008 (L(3)  X) P (dc)
+
R(T1)
12/16/2008 (L(3)  X) P (dc)
+
R(T1)
3/16/2009 (L(3)  X) P (dc)
+
R(T1)
6/16/2009 (L(3)  X) P (dc)
+
R(T1)
9/16/2009 (L(3)  X) P (dc)
+
R(T1)
12/16/2009 (L(3)  X) P (dc)
+
R(T1)
3/16/2010 (L(3)  X) P (dc)
+
R(T1)
6/16/2010 (L(3)  X)+ P (dc) R(T1)
9/16/2010 (L(3)  X)+ P (dc) R(T1)
12/16/2010 (L(3)  X) P (dc)
+
R(T1)
here dc is the percentage of the year between the reset date and the payment date.
In this particular case, we use the actual number of days divided by 360.
So if on any of the reset dates, (Spot) 3Mo LIBOR is less than the cap rate, the cash flow 3 months later is 0.
Suppose that on 9/16/06, spot 3month LIBOR is 5.2%.
In this case, the cash flow on 12/16/06 will be calculated as follows:
Reset Date: 9/16/2006
Pay Date 12/16/2006
Not Princ 10000000
Cap Rate 0.0478821
Days between: 91
dc 0.2527777778
Spot LIBOR 0.052
Cash Flow: $10,409.14
We know exactly how to value a certain cash flow that occurs on this future date. We would use the discount factor.
This is the discount rate from the Bloomberg "Curves" screen:
Note that the oneyear discount factor is 0.953072
Spot Rate 0.00483 4
0.9951845454 This is how the discount is computed, but we can't replicate
Bloomberg because of the day count conventions.
Note that each of the Reset/Payment events is a caplet.
As such, a cap is a portfolio of caplets.
Bloomberg's Calculation of Forward Rates
Variables:
d1 number of days from settlement date until the start date of the forward period (I.e., the
d2 number of days from settlement date until the end date of the forward period (I.e., the
r1 spot rate for d1 days.
r2 spot rate for d2 days.
FV = future value: FV = (1 + [(r2*d2)/360]) / (1 + [(r1*d1) / 360]))
f = forward rate = [(FV  1) / (d2d1)] * 360
So, for example for the caplet that is reset on 9/14/06, 12/14/2005
r1 0.0477
r2 0.0483
d1 274 9/14/2006
d2 365 12/14/2006
FV 1.0122221 0.0489708333 0.036305
f 0.0483512 Note that this corresponds to the Reset Rate used to value the
terest rate exposure,
their portfolio
ed to compute the cash flows, and
and payments.
e. the Reset Date). date of the forward period (I. months later is 0.e. ate of the forward period (I. the next Reset Date).. r1*d1) / 360])) .. d use the discount factor.
o the Reset Rate used to value the caplet that resets on 9/14/06. (See the next worksheet.) .
.
.
with mean and standard deviation computed as follows: Mean rate (= forward rate): 0.Once we understand the way the cash flows are determined on a cap we can think about how we would come up with a value Black's Model is widely used by Fixed Income Traders to characterize the value of caps. In BlackScholes. (or any finance model where there is no arbitrage). In this world. but we move to an equivalent riskneutral forward world. Thus we not only do the valuation in our equivalent riskneutral world. This trick allows us to handle the problem of having the bond price be a random variable at a future date. This means that for valuing this caplet.010443 std dev of log rate: 0. the expected future spot rate is the forward rate.4 . but assuming that the riskfree rate between now and then is constant.6 0.0483516 std dev (1Yr) 0. we do this in the "Equivalent riskneutral World" since only in this (equivalent) world do we know the dis (And that is the riskfree rate).1021909976 Notional Principal 10000000 So the cumulative density looks like this: Cumulative Probability CDF 1.83516% We also see that the volatility (used in describing the caplet value) is 11. Black's model was originally designed to ascertain the value of an option on a futures contract. To use Black's model.034477466 Var of log rate: 0. In the BlackScholes model. So turn to the 9/14/06 settlement. Black's Model assumes that the future spot rate is lognormally distributed.8 0. the numeraire is $1 at the time of delivery. the numeraire is $1 today.75 (Again approximate) Mean of log rate: 3. and its standard deviation is the same as in the "physical world.8%.010443 Term (Years) 0.118 Var * T 0.2 1 0. We see on the attached Bloomberg screen that the corresponding forward rate is 4. we simply take the expected value of the cont For convenience sake. the probability description of the 3month LIBOR spot rate. 9 months from now is lognormal.
07 90Day LIBOR Let me stress that this is not the market's distribution of the 90Day spot LIBOR in 9 months.8 0.01 0.05 0.03 0.2 0 0 0. I wrote a VB macro to evaluate a caplet using Black's model.03 0. and the type of input from Bloomberg: . we take the discounted expected cash flows from the option.5 2 1.04 0.6 0.5 0 0 0.5 4 Probability 3.06 0. Instead it is that as it relates to v Black's Model values each caplet in a distinct forward riskneutral world. C 0.4 0.5 3 2.05 0. As is the case in the BlackScholes Model.07 90Day LIBOR And the probability density function looks like this: 4.04 0.5 1 0.02 0.02 0. The difference is that whereas Black's model uses the forward riskneutral world corresponding to each caplet.01 0.06 0.
Derivatives can be calculated numerically by looking at the effect of a small change in a function's input on the value of the fun Example: The Caplet's Delta: Start with the current value of the function: #VALUE! .0478821 which is less than the expected 3month rate (in the f We look at the pdf graph and ask for the probability that 90LIBOR will exceed the strike rate. the floorlet is an analogous are identical to caps'. Such a situation is called Floors work analogously to caps. This is a method sometimes called We could. So in this case. 9 months from now is below the cap (floor) rate. We can think of a caplet as a call option on the future spot rate. floors. #VALUE! So in this case. As such one way to solve for the swap rate would be to use Solver to identify such a strike price: Numerical computation of derivatives and hedging. then this trader will receive the tenoradjusted differenc If 90Day LIBOR.8% probability that this caplet will be in the money when 2) What is the expected value under the truncated distributionwhere we only look at the portion above the exercis #VALUE! is the probability associated with So what we expect to get if we exercise: #VALUE! what this costs: #VALUE! Expected $ value (in 1 Year) #VALUE! 3) Bring this expected value back to today. and swaps. the value of such a swap is: #VALUE! The "Swap Rate" is that rate which such a swap holder pays fixed makes the value of the swap 0. prices are often expressed as implied volatilities. Consider a trader who is long the caplet and short the floorlet. If 90Day LIBOR. 9 months from now is above the cap rate. there is a putcallparity relationship between caps. Notice on the Bloomberg valuation screen that the implied volat as we move out in time.95307 #VALUE! Bloomberg gives 5326. #VALUE! The delta of a floorlet is N(d1): Furthermore. so much as it uses this model as a tool to c In particular. then this trader will pay the tenoradjusted differe These are exactly the same statedependent cash flows that this date's position in a receiver (of floating rate) swap fixed rate (equal to the cap/floor rate). there's a 51.0478821 Discount 0. Cap Rate: 0. the market does not use Black's model to value caps and floors. and receive 90Day LIBOR (90 days hence).85 Bloomberg's Intrinsic PV: The intuition behind this value is as follows: 1) What is the equivalent riskneutral probability that we would exercise this caplet? The strike rate is 0. #VALUE! For the most part. of course solve for a cap value by forcing all caplet vols to be the same. As in the valuation screen there is a (potentially) different implied vol for each caplet.
0001 #VALUE! Portfolio #VALUE! #VALUE! DV01 Start with the current value of the function: #VALUE! Identify the small change in the imput: 0.0001 Evaluate the function by adding this small change: #VALUE! Discount Effect: Discount: 0. Hedge Portfolio: Current Change in F New Long in the FRA: 1131.000000001 Evaluate the function by adding this small change: #VALUE! Change in the function: #VALUE! This corresponds to the effect of a small change in the Chg in F'n / Chg in Input: #VALUE! it equals N(d1) * P* tenor * disct Units: #VALUE! Numerical approximation to N(D1).7555555556 LN(disct)/T 0.06361799 add 1 bp: 0.095534 0.952997993 #VALUE! DV01 #VALUE! Vega: Start with the current value of the function: #VALUE! Identify the small change in the input: 0.000000001 Evaluate the function by adding this small change: #VALUE! Change in the function: #VALUE! Chg in F'n / Chg in Input: #VALUE! Units: #VALUE! .0001 1372.Identify the small change in the input: 0.95307 T 0.0104504167 Sell 1/Delta units of the cap: #VALUE! 0.06371799 New Discount: 0.
9 months from today 12/16/2005 38702 reset date 9/14/2006 38974 pay date 12/18/2006 39069 next expiry 12/14/2006 39065 #VALUE! CDF . Constructing the forward rate: take the expected value of the contract at expiration and discount this back to today. ot rate. ndle the problem of e rate between now and t we move to an equivalent the same as in the "physical world. forward: quivalent) world do we know the discount factor without doing a lot of work. ow we would come up with a value of these cash flows." he caplet value) is 11.8%.
m the option.07 0.08 s. Instead it is that as it relates to valuing an option (the forward risk neutral world).06 0. . CDF 0.06 0. The difference is that BlackScholes uses the equivalent riskneutral world.07 0.08 0.
which. h as it uses this model as a tool to characterize the prices. ot rate. .896 1131. of course is the forward rate. er will pay the tenoradjusted difference times the notional principal. (This is N(d1)) Again. #VALUE! We find the rate to be 4.07 Our.835%. Its institutional features #VALUE! receive the tenoradjusted difference times the notional principal. where the swap makes its owner pay the 90 days hence). luation screen that the implied volatilities are getting higher is a method sometimes called spot volatilities. his caplet will be in the money when it expires. in a receiver (of floating rate) swap.195 the expected 3month rate (in the forward riskneutral world) will exceed the strike rate. Bloomberg's Intrinsic PV: 1131.reconciliation: 0.00047 1186. ignoring daycount issues. is the probability associated with this truncated mean. nction's input on the value of the function. (This is N(d2)) ook at the portion above the exercise price. situation is called flat volatilities. the floorlet is an analogous put option.
P* tenor * disct ximation to N(D1). . o the effect of a small change in the forward rate on the Cap Value.
0488253935 .25 1.011228 6Mo Spot 0.023572 1. 12/14/2005 360 ting the forward rate: 3Mo Spot 0.0449125 3/14/2006 90 0.046625 6/14/2006 182 0.505556 1.0122063484 FV = (1 + [(r2*d2)/360]) / (1 + [(r1*d1)/360])) 0.
018 3.014 6.5E47 1.91E38 0.97E10 8.86E12 5.007 1.25E24 0.03E30 2.25E24 1.73E10 0.003 1.35E22 0.36E27 2.91E38 7.36E27 0.78E69 2.2E162 1.45E18 4.3E53 1.008 2.99E09 7.35E22 3.019 4.016 2.025 7.03E30 2.58E92 1.5E47 0.99E09 .3E53 1.2E162 1.21E79 1.42E42 2.2E314 0.42E42 0.45E18 0.61E13 2.002 6.9E109 4.9E109 4.022 9.95E20 4.02 4.36E27 2.94E34 6.51E13 2.006 1.004 4E131 4E131 4E131 0.6E213 0.58E11 0.12E09 7.3E53 0.5E47 1.07E11 7.12E12 4.012 2.4E18 4.99E20 0.69E15 0.03E30 0.38E61 9.42E42 2.53E16 2.99E20 4.024 5.38E61 9.6E213 6.21E79 0.Grid used to describe the probability of the future spot rate: Grid Pts CDF pdf Use the Normdist function which allows us cdf 0.61E13 0.011 1.94E34 0.001 1.005 4.2E162 0.2E314 to get the exact pdf: 1.53E16 0.38E61 0.58E92 1.94E34 6.017 1.01 1.91E38 7.78E69 0.58E11 7.33E22 3.021 2.44E15 9.58E92 0.12E12 0.9E109 0.25E24 1.69E15 9.21E79 1.73E10 7.78E69 2.49E16 2.015 2.026 8.027 7.6E213 6.023 2.013 7.009 9.
071 0.92E06 0.33113 0.999019 0.065 0.999996 #VALUE! 0.048 0.054 0.989965 0.0801 0.993507 0.026434 0.047 0.059 0.491893 0.96E08 5.16E08 5.051525 0.55E06 1.033205 0.092253 0.966489 0.191664 0.999648 0.00023 0.000343 0.997404 0.002288 0.035 0.00099 0.068 0.777251 0.042 0.014812 0.491893 0.905208 0.075717 0.69E07 0.257242 0.951677 0.03 1.002357 0.005225 0.64771 0.33E05 0.073888 0.020035 0.003542 0.000588 0.99988 8.029 3.010545 0.032 3.034 0.062 0.055 0.777251 0.046 0.0.47E05 3.98474 0.993507 0.00154 0.000932 0.039 0.997404 0.07 0.64771 0.020075 0.023467 0.999931 0.716652 0.059048 0.571993 0.076 0.020075 0.59E06 6.716652 0.038 0.031 8.033972 0.056 0.99988 0.041 0.257242 0.66E05 0.002288 0.999931 5.045 0.063 0.081426 0.871236 0.931642 0.069 0.000343 0.410467 0.037 0.136376 0.051 0.92E06 1.59E06 0.010696 0.998393 0.010545 0.005124 0.000626 0.995863 0.058 0.999409 0.066 0.905208 0.999409 0.02E05 0.000145 0.05 0.999996 .931642 0.136376 0.061 0.007555 0.052 0.977185 0.98474 0.057 0.11E05 0.053 0.04246 0.092253 0.035581 0.000113 0.999793 0.06 0.828776 0.015505 0.989965 0.69E07 3.04 0.966489 0.33E05 2.065578 0.049 0.002836 0.33113 0.059048 0.96E08 0.000239 0.67E06 8.028 5.064 0.871236 0.005124 0.571993 0.951677 0.005421 0.036 0.09E07 3.060599 0.044123 0.995863 0.033 0.999793 0.068943 0.998393 0.977185 0.00039 0.079337 0.043 0.000932 0.000113 8.828776 0.999648 0.191664 0.067 0.055288 0.999019 0.044 0.410467 0.035581 0.009531 0.001356 0.
04E14 7.55E07 .8E67 1.86E09 5.88E11 3.51E58 1.13E45 3.18E20 4.38E13 1.97E36 8.49E18 3.2E160 9.pdf 4.25E22 3.79E16 2.96E51 2.6E129 1.51E25 1.4E312 2E210 3.25E32 2.23E77 4.29E28 2.48E10 4.27E08 4.15E90 2.24E40 9.1E106 3.
004613 0.144617 0.376102 0.273151 0.918098 2.487676 2.5296 0.178441 0.156631 3.002745 0.070091 0.633142 3.119468 0.012273 0.312991 2.139444 2.000379 0.000174 .85E05 9.669716 3.3.651275 1.54869 3.078588 0.475311 0.001374 0.19E06 1.982118 0.004362 0.056433 1.05084 0.032373 0.030881 0.261614 0.00766 0.840149 3.729595 0.903083 3.020306 0.151167 1.618499 2.290077 0.07E05 0.805158 3.012556 0.766406 1.
105 Continuously Compd LIBOR .3Mo: 0.11 Fixed Rate: 0. we will value swaptions by assuming that the swap rate at the maturity of the option is Example: Consider an option to enter a 3Year swap in 5 years. the fixed "swap rate" will be the rate tha Example: Here's an already existing swap where the holder pays 6month LIBOR in exchange for 8% (fixed) (semiannual co Notional Principal: $100.000 0.1175 0.051.25 0. with semiannual payments and notional principal of: Scenario: LIBOR yield curve is flat at 6% per annum (continuous compounding).15Mo: 0.000.87153435 Value of Swap: Swaptions In the spirit of Black's model. A forward rate agreement (FRA) entails the exchange of a predetermined interest rate for the market rate at a pre A FRA is valued by assuming that the current market forward rate will be realized at at swap date.102 0.110441528 0.2 T: 5 IdentifyCash flows: . An interest rate swap is a portfolio of forward rate agreements.assuming that the realized future floating rates equal relevant the for 3) The value of the swap is the PV of these cash flows. 2) Calculate the cash flows that will accrue .102 Semiannual compounding) Continuously Compd LIBOR .1 Continuously Compd LIBOR . FRAs and swaps are priced to have 0 value at origination.5 $1. We will first review swaps.076 0.522. Vol at 5 years : 0. we saw that the oneperiod swap (I.000 6Mo LIBOR at last reset date: 0. The "price" is the prespecified fixed rate In the previous sheet. swap valuation entails the following steps: 1) Ascertain the relevant LIBOR forward rates. A swaption is an option to enter a swap agreement.008 0. (So at origination.9Mo: 0.5 $1.102 0.1210201602 0.5 $2.1075 0.25 0.92427096 1.97530991 0.75 0.08 Valuation: RiskNeutral Expected Time forward SemAnn Frwd term cash flow disct 0.e.. a FRA) will have a price equal to the re Thus.100.The third application of Black's model is to swaptions.
e.5 0.677057 0.2895562376 0. 1) Payer Swaption (I.e.2185745339 Verification of PutCall (Long a Payer Swaption and Writ .263302199 N(d2) 0.0709817037 2) Receiver Swaption (I.5 0. 7.5 0.6038411675 X N(d2) N(d1) 0.3961588325 X N(d2) Option Value: 2.3188140758 8 0.. (A Put option on the sw N(d2) 0. Right to receive fixed (pay floating LIBOR) over the swap's life). right to pay fixed over the swap's life).0035576486 Total Value discount.5 0.3594618667 6 0.697676 0.3385284372 Black's Model uses this annuity as the 7 0.5 0..5729585179 f N(d1) d2 0.5 0.348838163 6.Years ahead Discount tenor $ Multiplier 5.5 0.618783 0.4270414821 f N(d1) Option Value: 2.657047 0.3285234099 numeraire in valuing the swaption.3093916959 2.1839113965 N(d1) 0.637628 0.5 0.718924 0.5 0. Strike: d1 0.
.
.
.
on a prespecified notional principal. ixed "swap rate" will be the rate that makes the PV of these flows equal to 0.787.841 $1.ap agreement. d at at swap date.406. this is the forward swap rate. price" is the prespecified fixed rate that will be exchanged for the market rate in the future.176 rate at the maturity of the option is a lognormally distributed random variable. RA) will have a price equal to the relevant forward rate.060909 on a semiannual compounding basis. st rate for the market rate at a presepcified date.) nge for 8% (fixed) (semiannual compounding applies).267.072.811 $1. Semiannual compounding) PV $1.524 $4. floating rates equal relevant the forward rates. . ts and notional principal of: 100 0.) Since we have a flat curve.06 (translates into: 0.
03806 es this annuity as the 0.21857 0.) 0.0348983693 (The Expected Future Swap Rate equals 0. .03375 Total Swap Value: 0.0260106986 Verification of PutCall Parity (Long a Payer Swaption and Write a Receiver Swaption is equivalent to entering into the forward swap.valued in the forward risk neutral world. (A Put option on the swap rate).03693 uing the swaption.0374381524 0. 0.03478 0.0245618476 the forward swap rate.03921 0. 0.) wap's life).03584 0.062 (A Call option on the swap rate . Payer Swap Value 0.
.
.
.
s is the forward swap rate. .
This action might not be possible to undo. Are you sure you want to continue?