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My Understanding is : Interest rate cap are generally used by borrowers against increase of interest rate. Interest rate cap is said to be a bunch of “Call Option”.
However, The Borrower uses Put Option(Right to Sell the Future contract) to hedge against increase in interest rate.
So, how a Interest rate cap is a bunch of Call option and not Put option?
I don’t know where you got this information:
“The Borrower uses Put Option(Right to Sell the Future contract) to hedge.”
But it is wrong.
An interest rate option is priced at 100 – interest rate.
If you are borrowing you fear that the interest rate will rise eg current rate = 5% and might rise to 6%. If that happened, the option price would fall from 95 to 94. So, if you had an option to sell at 95 you could go to the market and buy at 94, making you a profit which compensates for the rise in interest rates.
To have a right so sell at a price you need a put option.
See P106 of our notes and lectures.
Sir – As you said in your example, we have to buy interest rate put option, so that in case interest rate increase the future price will decrease. So, We will exercise the option and will buy future from market at lower future price (due to increase in interest rate). For Borrowers have to buy put option. I m sorry, I didn’t understand how the statement about borrower buy put option is wrong. I also referred the notes again and it recites the same (If i understand correctly).
I am confused how a interest rate cap which is essentially a instrument for borrowers are said to be a set of call options.
Appreciate your support.
Sorry, I meant to say,that the original information you quoted was wrong ie
“Interest rate cap is said to be a bunch of call option” (I assume they meant buy some call options). My copy and paste picked up the wrong material.
Therefore, your concousion and my explanation are correct. For a borrower to protect against an interest rate rise, buy a put option that guarantees the right to sell at the higher price.
Is that Ok. Sorry for the error.
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