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“An interest rate cap is a series of call options on a notional amount of principal, exercisable at regular intervals over the term to expiry of the cap. The effect of a cap is to place an upper limit on the interest rate to be paid, and is therefore useful to a borrower of funds who will be paying interest at a future date. By purchasing a cap, a borrower will limit the net interest paid to the agreed cap strike price (less any premium paid for the cap). OTC caps are available for periods of up to ten years and can thus protect against long-term interest rate movements. As with all options, if interest rates were to move in a favourable direction, the buyer of the cap could let the option lapse and take advantage of the more favourable rates in the spot market.”
sir this paragraph was written in context of Interest rate cap. sir Cap is a series of put options as far as my understanding is concerned, and so i think this is wrong. Can you corroborate whether the exam kit is wrong here or not?
and sir buying a simple Put option which allows us to fix the maximum interest paid, is like saying that we have bought an interest rate cap?
I mean is there any difference between a put option and interest rate cap? Or the latter is just a jargon for the former?
An interest rate cap is fixing a maximum interest rate. Buying put options is a way of creating a cap. In the context of exam questions they are effectively the same, but speculators also use put options as a way of ‘gambling’ rather than buying them for the purpose of creating a cap.
The paragraph you quoted is correct (although is much more detailed than anything required in an exam answer).
sir but the paragraph is stating that the CAP is created using a series of “CALL OPTIONS” but isnt it created using “PUT OPTIONS”? that i think is the flaw in the paragraph
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