ASM example 16B

[yesactuary]

In example 16B, "The interest rate for the first year is (1/0.94)-1=0.06383 < 0.07, so there is no immediate payment on the cap. We must value the caplets for the 2nd and 3rd year...".

Like we calculated the interest rate for the 1st year. Here is how I calculated the interest rates for 2nd and 3rd year:

The bond price is (1/(1+R))^n.

For 2nd year: R=(1/0.88)^(1/2)-1=0.066
For 3rd year: R=(1/0.82)^(1/2)-1=0.068

Thus, these rates are both under cap rate 0.07, and there shouldn't be any payments on the cap. I don't think I'm right on this. There must be something I don't understand correctly. Could someone help me out here? Thanks a lot!

[JohnLocke]

not enough info, or I'm a retard. Both scenarios are equally likely.

[Abraham Weishaus]

If an option due one or two years from now is currently out-of-the-money, does that make it worthless?

[yesactuary]

If an option due one or two years from now is currently out-of-the-money, does that make it worthless?

The answer is no.

Thanks for pointing this out! I thought that might be the reason why we need to calculate the payments for 2nd and 3rd year.

[Abraham Weishaus]

As usual in Black-Scholes, you need the current price to calculate ln(S/K) and Se^- ... That does not imply that it is the price at expiry.

[yesactuary]

As usual in Black-Scholes, you need the current price to calculate ln(S/K) and Se^- ... That does not imply that it is the price at expiry.

Thank you!