Estimating the Payoff of an Interest Rate Cap and Floor on LIBOR with Different Interest Rates from a Collar Interest Rate

In this article, we estimate the payoff of an interest rate cap and floor on a LIBOR with different interest rates from a collar interest rate. An interest rate cap is a contract in which one party agrees to pay the other at specified period of time when the LIBOR with different interest rates exceeds the strike rate. The strike rate is known as the cap rate. For example, the buyer agrees to pay the seller over the next three years if LIBOR exceeds the cap rate of 5%. We are going to use different LIBOR rates and formulate the payoff strategies. In contrast, an interest rate floor is a contract in which one party agrees to pay the other at specified period of time when the LIBOR with different interest rates falls below the strike rate. The strike rate is known as the floor rate. For example, the buyer agrees to pay the seller over the next three years if LIBOR is less than the floor rate of 5%. Finally, an interest rate collar combines both a floor and a cap by using the same LIBOR over the same years. In this article, we purchase a cap and sell a floor and we purchase a floor and sell a cap to formulate the payoff strategies. Our purpose is to find whether arbitrageurs will buy, sell or hold a cap, a floor or collar to hedge against interest rate risk