JOURNAL ARTICLE
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Pricing of Caps and Floors. A Simplified Approach
Credit and Capital Markets – Kredit und Kapital, Vol. 20 (1987), Iss. 1 : pp. 1–21
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Hans H. Hubbes, London
Abstract
Pricing of Caps and Floors. A Simplified Approach
The Cox-Rubinstein option pricing model has been used to derive a method for pricing caps and floors. Caps and floors are interest rate options closely related to interest rate swaps. This feature has been used as the basis for defining a new instrument underlying the interest rate option. From the neutral hedging strategy based on this instrument, the model can be developed. It turns out that market prices of caps or floors can be reproduced or distinguished as too high or too low. The model thus fulfills its purpose and also indicates which hedging strategies to pursue.