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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 rate--which 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 three-month LIBOR with three-month tenor
Notional Principal of $10 million
Cap Rate 4.78821%
Current Date 12/14/05
Valuation Date 12/16/05
Maturity: 12/16/10
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) 3-Mo LIBOR is less than the cap rate, the cash flow 3 months later is 0.
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 one-year discount factor is 0.953072
r1*d1) / 360]))
o the Reset Rate used to value the caplet that resets on 9/14/06. (See the next worksheet.)
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.
Black's model was originally designed to ascertain the value of an option on a futures contract.
In the Black-Scholes model, (or any finance model where there is no arbitrage), we simply take the expected value of the cont
For convenience sake, we do this in the "Equivalent risk-neutral World" since only in this (equivalent) world do we know the dis
(And that is the risk-free rate).
In Black-Scholes, the numeraire is $1 today.
To use Black's model, the numeraire is $1 at the time of delivery. This trick allows us to handle the problem of
having the bond price be a random variable at a future date, but assuming that the risk-free rate between now and
then is constant. Thus we not only do the valuation in our equivalent risk-neutral world, but we move to an equivalent
risk-neutral forward world.
In this world, the expected future spot rate is the forward rate, and its standard deviation is the same as in the "physical world.
Black's Model assumes that the future spot rate is lognormally distributed.
So turn to the 9/14/06 settlement. We see on the attached Bloomberg screen that the corresponding
forward rate is 4.83516% We also see that the volatility (used in describing the caplet value) is 11.8%.
This means that for valuing this caplet, the probability description of the 3-month LIBOR spot rate, 9 months from
now is lognormal, with mean and standard deviation computed as follows:
Mean rate (= forward rate): 0.0483516
std dev (1-Yr) 0.118 Var * T 0.010443
Term (Years) 0.75 (Again approximate)
CDF
1.2
0.8
0.6
0.4
C
0.8
0.6
0.4
0.2
0
0 0.01 0.02 0.03 0.04 0.05 0.06 0.07
90-Day LIBOR
4.5
4
Probability
3.5
2.5
1.5
0.5
0
0 0.01 0.02 0.03 0.04 0.05 0.06 0.07
90-Day LIBOR
Let me stress that this is not the market's distribution of the 90-Day spot LIBOR in 9 months. Instead it is that as it relates to v
Black's Model values each caplet in a distinct forward risk-neutral world.
As is the case in the Black-Scholes Model, we take the discounted expected cash flows from the option. The difference is that
whereas Black's model uses the forward risk-neutral world corresponding to each caplet.
I wrote a VB macro to evaluate a caplet using Black's model, and the type of input from Bloomberg:
Cap Rate: 0.0478821 Discount 0.95307
#VALUE! Bloomberg gives 5326.85
Bloomberg's Intrinsic PV:
The intuition behind this value is as follows:
1) What is the equivalent risk-neutral probability that we would exercise this caplet?
The strike rate is 0.0478821 which is less than the expected 3-month rate (in the f
We look at the pdf graph and ask for the probability that 90-LIBOR will exceed the strike rate.
#VALUE! So in this case, there's a 51.8% probability that this caplet will be in the money when
2) What is the expected value under the truncated distribution--where 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. #VALUE!
For the most part, the market does not use Black's model to value caps and floors, so much as it uses this model as a tool to c
In particular, prices are often expressed as implied volatilities. Notice on the Bloomberg valuation screen that the implied volat
as we move out in time.
As in the valuation screen there is a (potentially) different implied vol for each caplet. This is a method sometimes called
We could, of course solve for a cap value by forcing all caplet vols to be the same. Such a situation is called
Floors work analogously to caps. We can think of a caplet as a call option on the future spot rate, the floorlet is an analogous
are identical to caps'.
The "Swap Rate" is that rate which such a swap holder pays fixed makes the value of the swap 0.
As such one way to solve for the swap rate would be to use Solver to identify such a strike price:
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:
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!
#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!
ow we would come up with a value of these cash flows.
take the expected value of the contract at expiration and discount this back to today. forward:
quivalent) world do we know the discount factor without doing a lot of work.
#VALUE!
CDF
CDF
s. Instead it is that as it relates to valuing an option (the forward risk neutral world).
m the option. The difference is that Black-Scholes uses the equivalent risk-neutral world,
Bloomberg's Intrinsic PV: 1131.07
Our,reconciliation: 0.00047 1186.896
1131.195
the expected 3-month rate (in the forward risk-neutral world)
will exceed the strike rate.
his caplet will be in the money when it expires. (This is N(d2))
ook at the portion above the exercise price.
is the probability associated with this truncated mean. (This is N(d1))
#VALUE!
Example:
Here's an already existing swap where the holder pays 6-month LIBOR in exchange for 8% (fixed) (semi-annual co
Notional Principal: $100,000,000
6-Mo LIBOR at last reset date: 0.102 Semi-annual compounding)
Continuously Compd LIBOR - 3-Mo: 0.1
Continuously Compd LIBOR - 9-Mo: 0.105
Continuously Compd LIBOR - 15-Mo: 0.11
Fixed Rate: 0.08
Valuation:
Risk-Neutral
Expected
Time forward Sem-Ann Frwd term cash flow disct
0.25 0.102 0.102 0.5 -$1,100,000 0.97530991
0.75 0.1075 0.110441528 0.5 -$1,522,076 0.92427096
1.25 0.1175 0.1210201602 0.5 -$2,051,008 0.87153435
Value of Swap:
Swaptions
In the spirit of Black's model, we will value swaptions by assuming that the swap rate at the maturity of the option is
Example: Consider an option to enter a 3-Year swap in 5 years, with semiannual payments and notional principal of:
Scenario:
LIBOR yield curve is flat at 6% per annum (continuous compounding).
Vol at 5 years : 0.2 T: 5
IdentifyCash flows:
Years ahead Discount tenor $ Multiplier
5.5 0.718924 0.5 0.3594618667
6 0.697676 0.5 0.348838163
6.5 0.677057 0.5 0.3385284372 Black's Model uses this annuity as the
7 0.657047 0.5 0.3285234099 numeraire in valuing the swaption.
7.5 0.637628 0.5 0.3188140758
8 0.618783 0.5 0.3093916959
1) Payer Swaption (I.e., right to pay fixed over the swap's life). Strike:
2) Receiver Swaption (I.e., Right to receive fixed (pay floating LIBOR) over the swap's life). (A Put option on the sw
st rate for the market rate at a pre-sepcified date, on a pre-specified notional principal.
d at at swap date.
price" is the pre-specified fixed rate that will be exchanged for the market rate in the future.
RA) will have a price equal to the relevant forward rate.
Semi-annual compounding)
PV
-$1,072,841
-$1,406,811
-$1,787,524
-$4,267,176
0.062 (A Call option on the swap rate -- valued in the forward risk neutral world.)
0.0374381524
0.0260106986