Interest Rate Option: Cap and Floor

CFA Level III Derivatives
#1

Hi,

Here is a practice exercise about Interest Rate Option Cap/Floor.

I think that the answer is B to protect against a decline in interest rates, but I have a question.

If a rates decline is expected, is “Sell Cap” also a possible option in general?
(There is no choice for the strategy in this question though.)
And which is the best choice, Selling Cap and Buying Floor, when you expect a protracted decline in interest rates?

Thank you.

Franklin Gale, CFA, is a portfolio manager. He purchases a portfolio of floating-rate notes whose coupon resets every six months to equal Libor + 50bp.
If he wants to be protected against a protracted decline in interest rates, he can:

--------------- Buy/Sell ------------------- Interest Rate Option ------------------------------
A. -------------- Sell ------------------------- Floor ------------------------------------------------
B. -------------- Buy ------------------------- Floor ------------------------------------------------
C. -------------- Buy ------------------------- Cap ------------------------------------------------

#2

Yes.

Just as selling a call option is a way to profit when you believe that the price of the underlying will decrease, as you will keep the premium.

1 Like
#3

Thank you.

#4

My pleasure.