Interest Rate Cap/Floor

[michaelwcao]

I have a tricky question… This has come up as part of a mock exam question. Thanks in advance for answering! But please quote your source!
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The periodic cash settlement for an interest rate cap (or floor) happens…
A. as the floating rate is determined in the market (like a Forward Rate Agreement);
B. one period after the floating rate is determined in the market (like an Interest Rate Swap).
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Again, please quote your source! Preferably, a curriculum source.
I’ve seen both sayings, so I’m confused now. I’m not yet to find the answer in the curriculum… Must be somewhere in there!

 

[ff8789]

it’s the same as FRA, floating rate in swap is very unique.

 

[ov25]

I think B

 

[maxmeomeo]

I think A. It should be th current floating rate like fRA, never seen predetermined floating rate like swap

 

[g3r41d]

Was trying to figure out what the quesion is asking. Anyway the calculation of payment for IR swaps and interest rates cap (or IR floor or call option on IR, etc) are similar. Payment at end of period is based on beginning interest rates. Thus (B) is correct.
FRA works based on the same concept as well. Understand that an A X B FRA is to go long on rates ([B-A] x 30 days) that expires at A x 30 days. Future payment (if it happens on B X 30 days) is dependent on beginning interest rates at contract expiry (A X 30 days). However FRA contracts payments are settled upon contract expiry, thus the need to discount back this “future payment” to current day when it expires based on current rate. That is why we are looking at the current period rate for FRAs which is (A)

 

[g3r41d]

If you are still confused. Go take a look at examples on how they value IRS swaps (difference in value between a fixed paying to a floating paying) and interest rates cap. You will notice the way payment settlements are calculated are similar to interest rates cap because essentially interest rates caps (series of call option on rates) are similar in nature to payer swaptions (the upside only potential of an IR swap).