MA 592: Mathematical Finance

Module 8: Swaps

Prof. Siddhartha Pratim Chakrabarty

Department of Mathematics
Indian Institute of Technology Guwahati
Prelude
1 Birth of over-the-counter swap market can be traced to a currency swap
negotiated in 1981 between IBM and World Bank.
2 (A) IBM: Had borrowings in German DM and Swiss Francs.
(B) World Bank: Had borrowings in US Dollars.
3 (A) World Bank (Restrictions on direct borrowing of German DM and
Swiss Francs): Agreed to make interest payment on IBM borrowings.
(B) IBM: In return agreed to make interest payments on the World Bank
borrowings.
4 Recall: Swap is an over-the-counter derivatives agreement between two
entities to exchange cash flows in the future.
5 The agreement defines the dates when the cash flows are to be paid and
the way in which they are calculated.
6 Typically: Calculation of the cash flows involves the future value of an
interest rate, and exchange rate or other market variable.
Mechanisms of Interest Rate Swaps
1 Most common over-the-counter derivative is a “plain vanilla” interest rate
swap.
2 Arrangement:
(A) Company agrees to pay cash flows equal to interest at a
pre-determined fixed rate, on a notional principal, for a number of
years.
(B) In return, the company receives interest at a floating rate, on the
same notional principal, for the same period of time.
3 The floating rate in most interest rate swap agreements was the London
Inter-bank Offered Rate (LIBOR) a .
4 LIBOR was the interest rate at which an AA-rated bank can borrow
money from other banks.
5 LIBOR rates were published each day for a number of different currencies,
for several borrowing periods, starting from one day and going on to one
year.
a LIBOR ceased to publish rates on June 30, 2023. Replaced with Secured

Overnight Financing Rate (SOFR) and Modified Mumbai Interbank Forward Outright
Rate (MMIFOR)
An Example
1 Three year swap initiated on March 8, 2017 between company A and
company C.
2 Company A agrees to pay company C an interest rate of 3% per annum,
on a notional principal of 100 million.
3 In return, company C agrees to pay company A, a six-month LIBOR.
4 (A) Company A: Fixed rate payer.
(B) Company C: Floating rate payer.
5 Agreement specification: Payments are to be exchanged every six months.
6 Accordingly 3% interest rate is quoted with semi-annual compounding.
Timeline of Payments
1 First exchange of payments: September 8, 2017 (Six months after
initiation of contact on March 8, 2017).
(A) Company A: Pays company C an amount of 1.5 million (1.5% of 100
million).
(B) Company C: Pays company A interest on 100 million principal at the
six-month LIBOR rate, prevailing six months prior to September 8,
2017, that is, six-month LIBOR rate as on March 8, 2017. Suppose
this rate was 2.2%. Accordingly, company C will pay company A, an
amount of 1.1 million (1.1% of 100 million).
2 Second exchange of payments: March 8, 2018 (One year after initiation of
contract on March 8, 2017).
(A) Company A pays company C an amount of 1.5 million.
(B) In return, company C pays an amount of 1.4 million to company C
(1.4% of 100 million, based on 2.8% six-month LIBOR rate, as on
September 8, 2017).
3 In totality, there are six payment exchanges on the swap:
(A) Fixed payments are always 1.5 million.
(B) Floating payments are calculated on the basis of six-month LIBOR
rate prevailing six months prior to the payment date.
Timeline of Payments (Contd ...)
Date LIBOR Rate Floating cash Fixed cash Net cash
(in %) flow received flow paid flow
Mar 8, 2017 2.20
Sep 8, 2017 2.80 +1.10 -1.50 -0.40
Mar 8, 2018 3.30 +1.40 -1.50 -0.10
Sep 8, 2018 3.50 +1.65 -1.50 +0.15
Mar 8, 2019 3.60 +1.75 -1.50 +0.25
Sep 8, 2019 3.90 +1.80 -1.50 +0.30
Mar 8, 2020 +1.95 -1.50 +0.45
(Mar 8, 2020) (+101.95) (-101.50) (+0.45)

Table: Cash flows for company A (in case, the final exchange of principal is
included).
Timeline of Payments (Contd ...)
1 Column 3 of Table 1: Cash flows from the long position in a floating-rate
bond, where the interest rate is six-month LIBOR.
2 Column 4 of Table 1: Cash flows from the short position in a fixed-rate
bond.
3 Table 1: The table shows that the swap can be regarded as the exchange
of a fixed rate bond for a floating interest rate bond.
(A) Company A: Long a floating rate bond and short a fixed rate bond.
(B) Company C: Long a fixed rate bond and short a floating rate bond.
Using the Swap to Transform a Liability
1 In the previous example: For company A, the swap could be used to
transform a floating rate loan into a fixed-rate loan.
2 Suppose that: Company A has arranged to borrow 100 million for three
years at LIBOR plus 10 basis points a .
3 After company A has entered into the swap (with company C) it has three
sets of cash flows:
(A) It pays LIBOR plus 0.1% to its outside lenders.
(B) It receives LIBOR under the terms of the swap.
(C) It pays 3% under the terms of the swap.
4 Accordingly, the three sets of cash flows net out to an interest rate
payment of 3.1%.
5 Thus: Company A has effectively transformed borrowings at a floating
rate of LIBOR plus 10 basis points into borrowings at a fixed rate of 3.1%.
a1 basis point=0.01% or 10 basis point=0.1%
Using the Swap to Transform a Liability (Contd ...)
1 A company wishing to transform a fixed-rate loan into a floating-rate loan
would enter into the opposite swap.
2 Suppose that company I has borrowed 100 million at 3.2% for three years
and wishes to switch to a floating rate, linked to LIBOR.
3 Accordingly, it enters into a swap with company C wherein Company I
pays LIBOR to company C and in return receives 2.97% from company C.
4 Consequently, there will be three cash flows for Company I:
(A) It pays 3.2% to outside lenders.
(B) It pays LIBOR under the terms of the swap.
(C) It receives 2.97% under the terms of the swap.
5 These three sets of cash flows net out to an interest rate payment of
LIBOR plus 0.23% (23 basis points).
6 Thus, for company I, the swap could have the effect of transforming
borrowings at a fixed rate of 3.2% into borrowings at a floating rate of
LIBOR plus 23 basis points.
Using the Swap to Transform an Asset
1 Swaps can also be used to transform the nature of an asset.
2 Consider company A in our example, with the swap agreement having the
effect of an asset earning a fixed rate of interest, into an asset earning a
floating rate of interest.
3 Suppose that company A owns 100 million in bonds that will provide an
interest at 2.7% per annum over the next three years.
4 After company A has entered into the swap, it has three sets of cash
flows:
(A) It receives 2.7% on the bonds.
(B) It receives LIBOR under the terms of the swap.
(C) It pays 3% under the terms of the swap.
5 These three sets of cash flow nets out an interest inflow of LIBOR minus
30 basis points.
6 Swap: Has transformed an asset earning 2.7%, into an asset earning
LIBOR minus 30 basis points.
Using the Swap to Transform an Asset (Contd ...)
1 Consider the example with Company I.
2 The swap could have the effect of transforming an asset earning a floating
interest rate, into an asset earning a fixed interest rate.
3 Suppose that company I has an investment of 100 million that yields
LIBOR minus 20 basis points.
4 After company I has entered into the swap, it has three sets of cash flows:

(A) It receives LIBOR minus 20 basis points on its investment.

(B) It pays LIBOR under the terms of the swap.
(C) It receives 2.97% under the terms of the swap.
5 The consequent net cash flow is an interest rate inflow of 2.97%.
6 Thus, one possible use of the swap for company I is to transform an asset
earning LIBOR minus 20 basis points, into an asset earning 2.77%.
Summary of Examples
Transformation of liabilities Transformation of assets
Floating liability to Fixed liability Fixed asset to Floating asset
Fixed liability to Floating liability Floating asset to Fixed asset
Table: Transformation types under interest rate swaps.
Organization of Trading
1 Regulators in the United States require that standard swaps be traded on
electronic platform.
2 As in other jurisdictions, they must then be cleared through central
counterparties (CCPs).
3 The swaps are therefore treated like futures contracts with initial and
variation margin being posted by both sides a .
4 Occasionally, a financial institution may be lucky enough to enter into
offsetting trades with two different non-financial companies, at about the
same time.
5 But in most scenarios, the financial institution must manage its risk, by
entering into opposite trade with another financial institution.
a Though like futures, there is no daily settlement in case of swaps
The Comparative Advantage Argument
1 A commonly put forward argument to explain the popularity of swaps
concerns the Comparative Advantage.
2 A “Comparative Advantage” is an advantage that leads to a company
being treated more favorably in one debt market than in another debt
market.
3 Consider the use of an interest rate swap to transform a liability.
4 Some companies have a comparative advantage when borrowing in
floating-rate markets, while some companies have a comparative
advantage when borrowing in fixed-rate markets.
5 When acquiring a new loan, it makes sense for a company to go to the
market where it has “Comparative Advantage”.
6 Consequently, the company may borrow fixed, when it actually wants
floating, or borrow floating, when it actually wants fixed, and then use the
swap, to transform a fixed-rate loan into a floating-rate loan and
vice-versa, respectively.
An Illustration
1 Suppose that two companies AAA and BBB both wish to borrow 10
million, for a period of five years and have been offered the rates as shown
in Table 4 a
Company Fixed rate Floating rate
Company AAA 4.0% 6-month LIBOR−0.1%
Company BBB 5.2% 6-month LIBOR+0.6%

Table: Borrowing rates offered to AAA and BBB

2 (A) Suppose that BBB wants to borrow at a fixed rate of interest.

(B) Suppose that AAA wants to borrow at a floating interest rate linked
to six-month LIBOR.
a AAA has a AAA credit rating and BBB has a BBB credit rating
An Illustration (Contd ...)
1 Obviously: BBB has to pay a higher rate of interest than AAA, in both
fixed and floating markets.
2 However: Difference between the two fixed rates (1.2%) > Difference
between the floating rates (0.7%).
3 Consequently:
(A) BBB appears to have a comparative advantage in the floating-rate
market.
(B) AAA appears to have a comparative advantage in the fixed-rate
market.
(C) This apparent anomaly → Swap being negotiated.
4 (A) AAA borrows fixed rate funds at 4.0% per annum.
(B) BBB borrows floating rate funds at LIBOR plus 0.6% per annum.
An Illustration (Contd ...)
1 How does this work:
(A) AAA agrees to pay BBB interest at six-month LIBOR on 10 million.
(B) BBB agrees to pay AAA interest at a fixed rate of 4.35% on 10
million.
2 AAA has three sets of interest rate cash flows:
(A) It pays 4% per annum to outside lenders.
(B) It receives 4.35% per annum from BBB.
(C) It pays LIBOR to BBB.
The net effect is that AAA pays LIBOR minus 0.35%, which is 0.25% less
than what it would pay, had it gone directly to floating-rate markets.
An Illustration (Contd ...)
1 BBB has three sets interest rate cash flows:
(A) It pays LIBOR plus 0.6% per annum to outside lender.
(B) It receives LIBOR from AAA.
(C) It pays 4.35% per annum per annum to AAA.
The net effect is that BBB pays 4.95%, which is 0.25% less than it would
pay, had it directly gone to fixed-rate markets.
2 In this example, the swap rate has been structured so that the net gain to
both the sides is the same, that is, 0.25% each.
3 The choice of 0.25% is given by the gain of 1.3% − 0.7% = 0.5% being
divided equally between both the parties of the swap agreement.
4 In case there is a financial institution brokering the swap transaction
between AAA and BBB, one possibility is that AAA borrows at LIBOR
minus 0.33%, BBB borrows at 4.97% and the financial institution gets
0.04%, that is, 0.5% is split as: 0.23% for AAA, 0.23% for BBB and
0.04% for the financial institution.
Valuation of Interest Rate Swaps
1 We now move on to the topic of valuation of interest rate swaps.
2 An interest rate swap is worth zero when it is first initiated.
3 After it has been in existence for sometime, its value may be positive or
negative.
4 Consider the swap between company A and company C.
5 The swap is a three-year deal entered into on March 8, 2017, with
semi-annual payments.
6 The first exchange of payments is known at the time the swap is
negotiated.
7 However, for the remaining five payments, the exchange amounts are
unknown at the time the swap is initiated.
An Example
1 Suppose that some time ago, a financial institution entered into a swap
where it agreed to make semi-annual payments at the rate of 3% per
annum and receive LIBOR, on a notional principal of 100 million.
2 The swap now has a remaining life of 1.25 years.
3 Payments, will therefore be made 0.25, 0.75 and 1.25 years from now.
4 The risk-free rates with continuous compounding for maturities of 3
months, 9 months and 15 months are 2.8%, 3.2% and 3.4%, respectively.
5 We suppose that the forward LIBOR rates for 3-to-9-month and
9-to-15-month periods are 3.429% and 3.734%.
6 The LIBOR rate applicable to the exchange, in 0.25 years, was determined
0.25 years ago and suppose it is 2.9% with semi-annual compounding.
7 The calculation of swap cash flows and the discounting of the cash flows
(all in millions) are shown in the next Table.
An Example (Contd ...)
Time Fixed Floating Net Discount Present value
(years) cash flow cash flow cash flow factor of net cash flow
0.25 −1.5000 +1.4500 −0.0500 0.9930 −0.0497
0.75 −1.5000 +1.7145 +0.2145 0.9763 +0.2094
1.25 −1.5000 +1.8670 +0.3670 0.9584 +0.3517
Total +0.5114

Table: Present value of net cash flows for the swap

The value of the swap is obtained by summing up the present values, which in
this case is +0.5114.
Fixed-for-Fixed Currency Swaps
1 Anothe popular type of swap is a fixed-for-fixed currency swap.
2 This involves exchanging “principal and interest payments” at a fixed rate
in one currency for “principal and interest payments” at a fixed rate in
another currency.
3 A currency swap agreement requires the principal to be specified in each
of the two currencies.
4 The principal amounts in each currency are usually exchanged at the
beginning and at the end of the life of the swap.
5 Usually, the principal amounts are chosen to be approximately equivalent,
using the exchange rate at the swap’s initiation.
6 But when they are exchanged at the end of the life of the swap, their
values may be quite different.
An Illustration
1 Consider a hypothetical five-year currency swap agreement between
British Petroleum (BP) and Barclays, entered on February 1, 2017.
2 Suppose that BP pays a fixed interest rate of 3% in USD to Barclays.
3 In return, BP receives a fixed interest rate of 4% in GBP from Barclays.
4 The principal amounts are $15 million and $ 10 million.
5 Interest rate payments ate made once in a year.
6 This is termed as “fixed-for-fixed” currency swap, since the interest rate in
both the currencies is fixed.
An Illustration (Contd ...)
Date $ cash flow (millions) £ cash flow (millions)
February 1, 2017 +15.00 −10.00
February 1, 2018 −0.45 +0.40
February 1, 2019 −0.45 +0.40
February 1, 2020 −0.45 +0.40
February 1, 2021 −0.45 +0.40
February 1, 2022 −15.45 +10.40
Table: Cash flow from the perspective of BP in the currency swap
Comparative Advantage: An Example
1 Currency swaps can be motivated by comparative advantage.
2 Suppose the five-year fixed-rate borrowing costs to General Electric (GE)
in US Dollars (USD) and Quantas Airways (QA) in Australian Dollars
(AUD) is as shown in the Table.
Company USD AUD
General Electric 5.0% 7.6%
Quantas Airways 7.0% 8.0%

Table: Borrowing rates which forms the basis for the currency swap

3 Observations from the data:

(A) AUD interest rates are higher than USD interest rates.
(B) GE is more creditworthy (better credit ratings) than QA, which is
evident because GE is offered a more favourable rate of interest in
both the currencies, as compared to QA.
Comparative Advantage: An Example (Contd ...)
1 Note: The spreads between rates paid by GE and QA, in the two markets
are not the same.
(A) QA−GE= 2.0% in USD market.
(B) QA−GE= 0.4% in AUD market.
2 This situation is similar to the comparative advantage argument example
seen previously. Accordingly:
(A) GE has a comparative advantage in the USD market.
(B) QA has a comparative advantage in the AUD market.
The Swap Setup
1 Suppose that GE wants to borrow 20 million AUD and QA wants to
borrow 15 million USD.
2 Suppose the currency exchange rate is 1 AUD= 0.75 USD.
3 Perfect situation for setting up the swap.
4 GE and QA each borrow in the market where they have a comparative
advantage.
5 Accordingly:
(A) GE borrows USD.
(B) QA borrows AUD.
6 Then both of them use a currency swap to transform:
(A) GE’s loan into a AUD loan.
(B) QA’s loan into a USD loan.
The Swap Setup (Contd ...)
1 Now:
(A) Difference between the USD interest rates= 2.0%.
(B) Difference between the AUD interest rates= 0.4%.
(C) Expect: Total gain for all parties= 2.0% − 0.4% = 1.6%.
2 Next Question: How can the swap be arranged?
3 One way to set up the swap: Swap might be brokered by a financial
institution.
(A) GE borrows in USD.
(B) QA borrows in AUD.
The Swap Setup (Contd ...)
1 Effect of the swap:
(A) GE: Transform the USD interest rate of 5% to AUD interest rate of
6.9%. Consequently, GE is 0.7% better off than it would have been
had it gone directly to the AUD market.
(B) QA: Transform an AUD loan at 8% to USD loan at 6.3%.
Consequently, QA is 0.7% better off than it would have been had it
gone directly to the USD market.
(C) The financial institution gains 1.3% on the USD cash flows and loses
1.1% on the AUD cash flows. If we ignore the difference between the
two currencies, the financial institution makes a net gain of 0.2%.
(D) The total gain to all parties is 1.6%.
2 Each year the financial institution gains USD 1, 95, 000 (= 1.3% of USD
15 million) and loses AUD 2, 20, 000 (= 1.1% of AUD 20 million).
3 The financial institution can avoid any foreign exchange risk by buying
AUD 2,20,000 in the forward market, resulting in the net gain of:

USD 1, 95, 000 − USD (2, 20, 000 × 0.75) = USD 30, 000.
Variations of the Vanilla Swap
1 Many interest swaps involve relatively minor variations to the plain vanilla
structure.
2 In some swaps, the notional principal changes with time, in a
pre-determined way.
3 (A) Swaps, where the notional principal is an increasing function of time
are known as “step-up-swaps”.
(B) Swaps, where the notional principal is a decreasing function of time
are known as “amortizing swaps”
4 (A) Step-up-swaps could be useful for a construction company that
intends to borrow increasing amounts of money at floating rates to
finance a particular project and wants to swap to a fixed-rate funding.
(B) An amortizing swap could be used by a company that has fixed-rate
borrowings with a certain pre-payment schedule and wants to swap
to borrowings at a floating rate.
Swap Setup and Mathematical Formulation
1 We will restrict ourselves to the notion of interest rate swaps here:
(A) A pays B a floating rate.
(B) B pays A a fixed rate.
(C) Common notional principal.
2 Notations:
(A) R: Fixed interest rate.
(B) L(Ti−1 , Ti ): Floating interest rate corresponding to the time interval
[Ti−1 , Ti ], for i = 1, 2, . . . , n.
(C) Both interest rates are in annual terms.
3 We assume that the payment dates at which the difference between the
fixed-rate and floating-rate is paid are T1 , T2 , . . . , Tn and they are equally
spaced out, with each interval being ∆T = Ti − Ti−1 .
Swap Setup and Mathematical Formulation (Contd ...)
1 Perspective of A: The party paying the floating rate and receiving the
fixed rate at time Ti , pays in multiples of:

Ci = ∆T [L(Ti−1 , Ti ) − R] .

2 Since swap is a sequence of claims Ci , therefore, in order to price (value)

of the swap, it is sufficient to price claims Ci .
3 Consider a time window of (S, T ), for which we denote by P(S, T ), the
time S price of the zero-coupon bond, with maturity T and face value of
1, that is, P(T , T ) = 1.
P(t, S) e −R(S−t)
4 We have: = −R(T −t) = e R(T −S) ≡ (1 + R(T − S)).
P(t, T ) e
Swap Setup and Mathematical Formulation (Contd ...)
1 We choose: t = Ti−1 , S = Ti−1 and T = Ti .
2 Accordingly:

P(Ti−1 , Ti−1 )
= 1 + ∆TL(Ti−1 , Ti ),
P(Ti−1 , Ti )
⇒ 1 − P(Ti−1 , Ti ) = ∆TP(Ti−1 , Ti )L(Ti−1 , Ti ),
1 − P(Ti−1 , Ti )
⇒ L(Ti−1 , Ti ) = .
∆TP(Ti−1 , Ti )

3 Therefore, the payoff is:

1
Ci = ∆T [L(Ti−1 , Ti ) − R] = − (1 + ∆TR).
P(Ti−1 , Ti )
Swap Setup and Mathematical Formulation (Contd ...)
1
1 Term 1: Value at time t < T0 of the payoff paid a time Ti is
P(Ti−1 , Ti )
equal to P(t, Ti−1 ).
2 How Term 1: If we invest P(t, Ti−1 ) at time t, buying a bond with
maturity Ti−1 , we get 1 unit of currency at time Ti−1 , with which we buy
1
exactly bonds of maturity Ti and consequently collect
P(Ti−1 , Ti )
1
at time Ti .
P(Ti−1 , Ti )
3 Term 2: Value at time t < T0 of (1 + R∆T ) is (1 + R∆T )P(t, Ti ).
4 How Term 2: If we receive (1 + R∆T )P(t, Ti ), to issue (1 + R∆T )
bonds at time t, with maturity Ti , then we pay an amount of (1 + R∆T )
at time Ti .
Swap Setup and Mathematical Formulation (Contd ...)
1 Combining, we see that the time t price, Ci (t), of payoff Ci is:

Ci (t) = P(t, Ti−1 ) − (1 + R∆T )P(t, Ti ).

2 Therefore, the price S(t) of the swap at time t is:

n
X n
X
S(t) = Ci (t) = [P(t, Ti−1 ) − (1 + R∆T )P(t, Ti )] .
i=1 i=1

3 Simplifying the previous expression, we get the price of the swap, in terms
of bond prices as:
n
X
S(t) = [P(t, T0 ) − P(t, Tn )] − R∆T P(t, Ti ).
i=1
Swap Setup and Mathematical Formulation (Contd ...)
1 The swap rate R is the fixed rate to be traded for the floating rate, such
that the cost of entering the swap at the initial time 0 is equal to zero (In
other words, there is no exchange of money at the initial time).
2 Therefore S(0) = 0, which leads to:

P(0, T0 ) − P(0, Tn )
R= n .
P
∆T P(0, Ti )
i=1

3 In addition, when T0 = 0, we get:

1 − P(0, Tn )
R= n .
P
∆T P(0, Ti )
i=1

4 Remark: In principle, this is the rate that the parties in the swap contract
should agree on if they want the initial cost of the contract to be zero.
Swapation
1 Swapation: It is an option to enter a swap contract with maturity Tn and
payments at dates Ti (T < T1 < T2 < · · · < Tn ) at a pre-determined
swapation rate R.
e
2 Let us consider a swapation, by which the holder has an option to start
paying the fixed rate Re and receiving the floating rate, beginning at time
T.
3 The holder of the swapation would exercise it, if the swapation rate Re is
no greater than the swap rate R = R(T ) at time T (which makes the
value of the swap zero), for the swap starting at time t = T and maturing
at t = Tn a .
4 Therefore, with t = T = T0 :
n
X
S(T ) = 1 − R∆T P(T , Ti ) − P(T , Tn ).
i=1

a If R
e > R(T ), then the holder could simply enter the swap at R(T ) and be better
off
Swapation (Contd ...)
1 The time-t value of the swapation is equal to the positive part of the
time-t value of the swap, that is, equal to the time-t value of the payoff
max[S(T ), 0].
2 The statement is true because the swapation will be exercised at time T
only if its value is positive at that time.
3 Now:
n
X
R∆T P(T , Ti ) + P(T , Tn )
i=1

is the value of a coupon bond that pays coupons R∆T at times Ti , 1 at

time Tn and matures at time Tn .
4 Therefore max[S(T ), 0] has the form of a put option on a coupon bond
with a strike price equal to 1.
5 Thus, the problem of pricing a swapation reduces to the pricing of a put
option on coupon bonds.
Caplets, Caps and Floors
1 A cap is another popular interest rate derivative.
(A) By floating a cap, the person who has to pay a floating interest rate
is assured that the amount to be paid will never be more than a
pre-determined cap rate.
2 A floor guarantees that someone paying a floating interest rate will never
pay less than a pre-determined floor rate.
3 Often contracts include both caps and floors.
4 For illustrative purpose, we only consider the case of caps (the analysis for
floors is similar).
Caplets, Caps and Floors (Contd ...)
1 A cap is a cash flow of several caplets, each with time Ti payoff being
given by:
C = ∆T max [L(Ti−1 , Ti ) − RC , 0] ,
where
(A) L = L(Ti−1 , Ti ) is the LIBOR spot rate (in annual terms).
(B) RC is the cap rate (in annual terms).
2 Holder of the caplet receives the difference between the LIBOR rate and
the cap rate, corresponding to the period ∆T , if the LIBOR rate is higher
than the cap rate.
3 Recall that:
1 − P(Ti−1 , Ti )
L(Ti−1 , Ti )∆T = .
P(Ti−1 , Ti )
4 Define: L := L(Ti−1 , Ti ) and P := P(Ti−1 , Ti ).
1−P 1
5 Accordingly: L∆T = = − 1.
P P
Caplets, Caps and Floors (Contd ...)
1 Thus, the caplet payoff is given by:
 
1
C = max − (1 + RC ∆T ) , 0
P
 
1 + RC ∆T 1
= max − P, 0 .
P 1 + RC ∆T

1
2 Denoting: X := , we get the payoff of the caplet at time Ti as:
1 + RC ∆T
1
C = max (X − P, 0) .
XP