Calculating interest rate Caps and Floors using a Binomial Tree Galabe Sampid Marius, Keskus Eren, & Celestin Kamta

Abstract In this paper, we give a brief description of the meaning of an interest rate Caps and Floors in the LIBOR market; and then try to create an application in MATLAB to value Caps and Floors at different levels using a binomial tree. We do not go into details of interest rate Caps and Floors since our task is to create an application to value Caps and Floors using a binomial tree.

Interest Rate Caps and Floor What is an interest rate Cap? An interest rate cap is a series of European call options (also known as caplets) on a specified interest rate, usually the LIBOR interest rate. The buyer of the cap receives money if on the maturity of any of the caplets, the reference or the underlying rate exceeds the agreed strike price of the cap.

The payoff diagram is as seen in figure 1 bellow Floating Interest Rate No Cap gain Reference Rate Cap Rate Fig 1

What is an interest rate Floor? An Interest rate floor is a series of European put options (also known as "floorlets") on a specified reference rate, usually LIBOR. The buyer of the floor receives money if on the maturity of any of the floorlets; the reference rate is fixed below the agreed strike price of the floor.

The payoff diagram is as seen in figure 2 bellow Floating interest Rate Floor No Floor gain Floor Rate Reference Rate Fig 2

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