PRMIA Exam 8006 Topic 5 Question 45 Discussion

Interest rate caps are effectively call options on an underlying interest rate that protect the buyer of the cap against a rise in interest rates over the agreed exercise rate. As with options, the premium on the cap depends upon the volatility of the underlying rates as one of its variables. A floor is the exact opposite of a cap, ie it is effectively a put option on an underlying interest rate that protects the buyer of the floor against a fall in interest rates below the agreed exercise rate. Therefore statements I and II are correct.

A cap protects a borrower against a rise in interest rates beyond a point, and a floor protects a lender against a fall in interest rates below a point.

A collar is a combination of a long cap and a short floor, the idea being that the premium due on the cap is offset partly by the premium earned on the short floor position. Therefore a collar is less expensive than a cap or a floor.

Caps, floors and collars provide a hedge against interest rate risks. Therefore statement III is correct too. However. they do not always provide protection against spreads changing, as the rate other than the one referenced by the cap or the floor may change causing the spread to change. Therefore statement IV is incorrect.