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Interest Rate Options

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Published: 12th August 2014 by William Webster

Interest rate caps are a string of options on forward starting Libor. The individual option is called a “caplet” with the combined sum of each caplet’s value giving the cap price or premium.

Forward interest rates are calculated from the par yield curve. To help understand them a simple example helps.

If you borrow money for six months and deposit it for three months there is a rate of interest that you need to receive on your deposit between month three and month six in order to give you sufficient cash to repay your initial borrowing with interest. This is the breakeven or forward rate:

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