Difference Between Cap And Floor Option

An interest rate floor is an agreed upon rate in the lower range of rates associated with a floating rate loan product.

Difference between cap and floor option.

Caps are either offered over the counter by dealers or embedded in a security. They are most frequently taken out for periods of between 2 and 5 years although this can vary considerably. Caps and floors are based on interest rates and have multiple settlement dates a single data cap is a caplet and a single date floor is a floorlet. Like other options the buyer will pay a premium to purchase the option so the buyer faces credit risk.

Payoff rule for a typical cap each payment date the cap pays the difference if positive between a floating index rate and the cap rate. The difference between the strike price and the boundaries is known as the cap interval. An interest rate cap is a derivative in which the buyer receives payments at the end of each period in which the interest rate exceeds the agreed strike price an example of a cap would be an agreement to receive a payment for each month the libor rate exceeds 2 5. Interest rate floors are utilized in derivative.

While this boundary limits the profit potential for the holder it comes at a reduced cost. This creates a gap between the volatilities of caps and swaptions which in turn provides an opportunity for investors to take views on future correlations and accordingly execute their trades.