Caps And Floors To Replicate Swaps

This course is designed to provide a conceptual overview of the valuation of interest rate swaps caps and floors.

Caps and floors to replicate swaps. Hagan gorilla science 11 palisade plaza edgewater nj 07020 phagan1954 hotmail com 1. Although derivatives valuation involves complex math equations this course focuses on concepts not formulas. If rates stay below the hedged swap rate 1 70 in the graph below. A cap purchase floor swap pay fixed rate receive floating rate a quick look at the cap payoff rate will bear this relationship out.

Thus is you work out the replication procedure you will find that cms replication is exact when you replicate on cash settled swaption at least when delta 0 that is for cms with fixing in arrears because hagan s street approximation is no longer an approximation. They are most frequently taken out for periods of between 2 and 5 years although this can vary considerably. However in order to use these tools effectively a borrower needs trustworthy advice to select the right hedge tool and to negotiate attractive terms and competitive pricing. At an 11 reset the cap would make a payment of 11 10 1.

In a cash settled swaption the payoff is settled using the cash annuity contractually computed using the swap rate. When considering a swap it s important to remember the hedger s potential opportunity cost. Here we focus on a single class of deals the constant maturity swaps caps and floors. Caps which placed a limit on any interest rate rises.

Pricing cms swaps caps and floors patrick s. A collar is simply a swap with a range the floor and cap customized by the hedger to meet their unique goals and objectives. Featured articles august 11 2010 an introduction to caps floors collars swaps and swaptions. Collars which protected customers from interest rate fluctuations.

Suppose a 10 cap was sold directly. An interest rate floor is an agreed upon rate in the lower range of rates associated with a floating rate loan product. When considering a collar one should. At 9 reset the cap would make no payment.

Interest rate swaps and interest rate caps can be effective hedge tools to minimize interest rate risk. We develop a framework that leads to the standard methodology for pricing these deals. Interest rate floors are utilized in derivative.