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Caplets
T0
T1
Price of Caplet
The time-T0 value of the caplet is
P(T0 , T1 )(L(T0 , T1 ) )+
= (1 + )
1
1+
+
P(T0 , T1 )
T0
T1
Caps
T0
T1
Tn1 Tn
Floors
A floor
is the converse to a cap,
protects against low interest rates,
is a strip of floorlets with Ti -cash flows
( L(Ti1 , Ti ))+ .
T0
T1
Tn1 Tn
P(t,T
P 0 )P(t,Tn )
ni=1 P(t,Ti )
(L(Ti1 , Ti ) )+
Ti
( L(Ti1 , Ti ))+
p
.
d1,2 =
Ti1 t
: Black (or relative) volatility (same for all caplets/floorlets of a cap/floor).
Interest Rate Models
(L(Ti1 , Ti ) )+
Ti
( L(Ti1 , Ti ))+
p
Ti1 t (D(D) + (D))
F (t, Ti1 , Ti )
p
.
Ti1 t
Cap/floor prices are quoted in terms of their Black or normal implied volatilities.
Typically: t = 0, T0 = = Ti Ti1 with
= three months (US market)
= half a year (euro market)
NormalATMVol(bps)
33.23
46.94
60.15
70.25
77.76
83.54
85.60
86.46
86.94
86.52
84.08
79.81
73.01
100
80
80
60
60
40
40
20
20
10
15
20
25
CapATMPrice(%)
0.08%
0.35%
0.84%
1.61%
2.54%
3.60%
4.60%
5.62%
6.65%
7.67%
12.38%
16.15%
22.35%
100
Maturity(yrs)
1
2
3
4
5
6
7
8
9
10
15
20
30
30
Maturity (yrs)
It is a challenge for any interest rate model to match the given volatility curve.
Interest Rate Models