Afterlife

An interest rate cap is a derivative
in which the buyer receives money at the end of each period in which an
interest rate exceeds the agreed strike price.
An example of a cap would be an agreement to receive money for each month the LIBOR rate exceeds 2.5%.

The interest
rate cap can be analyzed as a series of European call
options or caplets
which exists for each period the cap agreement is in existence.

In formulas a
caplet payoff on a rate L struck
at K is

where N is the
notional value exchanged and α is the day count fraction corresponding to the period to which
L applies.

For example
suppose you own the following caplet

· 6 month USD LIBOR rate

· Expiry of 1st February 2007

· Struck at 2.5%

· Notional of 1 million dollars.

Then if the USD
LIBOR rate sets at 3% on 1st February you receive 1m*0.5*max(0.03-0.025,0) =
$2500. Customarily the payment is made at the end of the rate period, in this
case on 1st August.

Basically, this theory behind is a risk product uses the formula will result in protection in rising interest rate. Hmmm does it mean that my current housing loan using Interest Rate Cap/Floor ?

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