Cap and Floor

A bank's exposure: $100 million debt obligation next 2 years; quarterly coupon, floating(90D LIBOR)

Following is an excerpt from a bank manager's memo:

• "Rather than using a cap or floor, the bank can effectively manage its exposure to interest rates resulting from the 2-year funding requirement by taking long positions in a series of put options on fixed-income instruments with expiration dates that coincide with the payment dates on the floating-rate note."
• "As a cheaper alternative, the bank can effectively manage its exposure to interest rates resulting from the 2-year funding requirement by creating a collar using long positions in a series of call options on interest rates and long positions in a series of call options on fixed-income instruments, all of which would have expiration dates that coincide with the payment dates on the floating-rate note."

Mitigating the interest rate rise risk

approach		Underlying	Long/short	IR↑	IR↓
	Interest rate cap	Interest rates	Long	↑(**)
Cap or floor alternative	Put	Fixed-income instruments	Long	↑
Artificial collar (*)(***)	Call	Interest rates	Long	↑	↓
Artificial collar (*)(****)	Call	Fixed-income instruments	Long Short	↑	↓

(*) Long cap & Short floor
(**) It means the value increases when the interest rate rises.
A long cap can be replicated either through (1) long put on fixed-income instruments or (2) long call on interest rates.
Short floor can be replicated either through (1) short call on fixed-income instruments or (2) short put on interest rates.
(***)Long cap
(****)Short floor