Caps and Floors
A cap is a portfolio of call options on LIBOR. It has the effect of guaranteeing that the interest rate in each of a number of future periods will not rise above a certain level Payoff at time tk+1 is Lδk max(Rk-RK, 0) where L is the principal, δk =tk+1-tk , RK is the cap rate, and Rk is the rate at time tk for the period between tk and tk+1 A floor is similarly a portfolio of put options on LIBOR. Payoff at time tk+1 is Lδk max(RK -Rk , 0) Options, Futures, and Other Derivatives, 7th Edition, Copyright © John C. Hull 2008
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