Chapter 24

Caps and Floors

This chapter was drafted on July 2, 2012, the day that the Barclays PLC chief executive officer resigned in the wake of the $451 million in fines levied on Barclays for the manipulation of LIBOR. Barclays Chairman Marcus Agius resigned on July 1. Given that LIBOR is the most common reference rate that has historically been used as the reference rate in caps and floors, big changes lie (no pun intended) ahead for the LIBOR market and the related market in caps and floors. LIBOR and the market for interest rate derivatives are so tightly tied together that a Heath, Jarrow, and Morton (HJM) variation called the “LIBOR market model” is described by some as the industry standard model for pricing interest rate derivatives. The LIBOR market model is a very useful point of reference and we recommend that serious readers review Riccardo Rebonato’s excellent book Modern Pricing of Interest-Rate Derivatives: The LIBOR Market Model and Beyond (John Wiley & Sons, 2012) for more on that specific implementation. In this chapter, the nature of the reference rate is irrelevant to the analysis, provided that the reference rate is determined in a competitive market with transparent price discovery and the usual assumptions of perfect competition. This description, obviously, does not apply to LIBOR. Therefore any results from the following methods have to be adjusted for the result of criminal activity and market manipulation. The authors recommend that readers initiate ...

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