The accrual period is calculated according to the start date and end date of a cash flow plus day count convention The most common used yield curve is continuously compounded.Īnother key for accurately pricing an outstanding cap/floor is to construct an arbitrage-free volatility surface. Then you need to construct interest zero rate curve by bootstrapping the most liquid interest rate instruments in the market. The cash flow generation is based on the start time, end time and payment frequency, plus calendar (holidays), business convention (e.g., modified following, following, etc.) and whether sticky month end. The first key to value a cap is to generate the cash flows. Interest rate caps are valued via the Black model in the market. The holder gets a payment when the underlying interest rate exceeds a specified strike rate.ĭ 1, 2 = l n ( F i K ) ± 0.5 σ i 2 T i σ i T i d_ d 1, 2 = σ i T i l n ( K F i ) ± 0. Investors will benefit from any risk in interest rates above the strike. Investors use caps to hedge against the risk associated with floating interest rate. The buyer needs to pay an up-front premium to the seller.Ĭaps are frequently purchased by issuers of floating rate debt who wish to protect themselves from the increased financing costs that would result from a rise in interest rates. The buyer would get paid if LIBOR rose above 2.0% otherwise, he would receive nothing if LIBOR fell below it. The exercise is done automatically that is different from any types of options.įor example, let the strike be 2.0%. The payment frequency could be monthly, quarterly or semiannually. The buyer receives payments at the end of each period when the interest rate exceeds the strike. An interest rate cap is a financial contract between two parties that provides an interest rate ceiling or cap on the floating rate payments.Īn interest rate cap actually consists of a series of European call options (caplets) on interest rates.