Interest rate options

CFA Level II Derivatives
#1

Hi all.

I am confused with the valuation of interest rate cap example.

Given the two-period interest rate tree: the exercise rate is 5.5% and notional principal is $1m

t=0, r=3%

t=1, upper node= 5% and lower node= 3%

t=2, upper node= 10%, middle node= 7% and lower node= 5%

For calculating the value of the option in C++, why is the value is calculated in the below:

1m*(10%-5%) but not 1m*(10%-5.5%)/1.1

i am confused why we dun need to discount the cashflow.

THANKs!!!

#2

Not enough info to be sure my answer is correct, but if the interest rate option is a two year option, then you must not disount to find the value in t2.

Maybe that is it?

And I guess above, it shouldsay: 1m*(10%-5 .5 %) but not 1m*(10%-5.5%)/1.1

#3

may i know why i should not discount the cashflow?

For 2 yr options, isnt that the payoff would be at yr 3 and thus we need to discount the payoff by 2nd year interest rate?

Thanks!

#4

For a 2 yr option, payout is end of year 2.

#5

Hello, is this in the LOS?

#6

thx a lot shark!

this is included in LOS