Explanation:
A caplet, at the time of expiration, pays the difference between the short rate and a strike, if the difference is positive, on some nominal amount. The short rate refers to the interest rate on a short-term loan, while the strike is the predetermined rate at which the holder of an option can buy or sell the underlying asset. If the short rate exceeds the strike, the holder of the caplet is compensated for the difference. This is because the holder has the right, but not the obligation, to borrow at the strike rate, and if the short rate is higher, the holder can borrow at the strike rate and lend at the short rate, making a profit equal to the difference between the two rates. This profit is paid by the issuer of the caplet to the holder. Therefore, the value of a caplet is directly linked to the distribution of the short rate at the time of the caplet's expiration.
Choice B is incorrect. A caplet does not compensate the difference between the short rate and a strike if it's negative. In fact, if the short rate is less than the strike price, there will be no payout from a caplet. The holder of a caplet only benefits when the short rate exceeds the strike price.
Choice C is incorrect. A caplet does not compensate based on an increase in strike price at expiration. The payout of a caplet depends on whether or not the short rate exceeds the predetermined strike price, and not on changes in that strike price itself.
Choice D is incorrect. A caplet does not simply compensate for any given short rate irrespective of its relation to the strike price at expiration time. It specifically pays out when this short rate surpasses its predetermined level (the 'strike'). If it doesn't exceed this level, there will be no compensation from holding a caplet.
Things to Remember
Caplets are call options on interest rates, where the holder has the right to receive a payment if the reference interest rate (short rate) exceeds the strike rate at expiration.
Caplets are commonly used in interest rate markets to hedge against rising interest
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Q.1671 Deterministic volatility functions and models are widely used by market makers to exploit the benefits of interest rate options. Like in trading caplets, the value of caplets depends on the distribution of short-rates at the time of expiration of these caplets. So, the flexibility of deterministic functions can be used to match market prices of caplets with distinctive expiration dates. At expiration, what does a caplet pay?
A
A caplet compensates the difference between the short rate and a strike, if positive.
B
A caplet compensates the difference between the short rate and a strike, if negative.
C
A caplet compensates the strike price at the time of expiration if the strike price increases.
D
A caplet compensates the short rate only irrespective of the strike price at the time of expiration.