Overview
The most basic types of fixed income derivatives that are widely used are caps and floors, which are used to limit interest rate risk exposure to either the upside or the downside.
- A caplet is a call option on a interest rate for a single specified period
- A cap is a series of caplets
Thus an investor can limit the amount of interest that she will have to pay on a variable rate loan by buying a caplet on each coupon payment of the loan. (In other words, buying a cap).
- A floorlet is a put option on a interest rate for a single specified period
- A floor is a series of floorlets
Pricing using Black Model
The standard model that is used to price, or at least quote the price, of caps and floors is Blacks Model.