Hi,i understand it, a cap can be represented as a portfolio of options on individual forward rates. In contrast, a swaption can be viewed as an option on a portfolio of individual forward rates. Therefore a no-arbitrage relationship must be satisfied by cap and swaption vols.Why do I keep hearing thats you can't compare the vols in each market?thankst

QuoteOriginally posted by: nomoretechnoHi,i understand it, a cap can be represented as a portfolio of options on individual forward rates. In contrast, a swaption can be viewed as an option on a portfolio of individual forward rates. Therefore a no-arbitrage relationship must be satisfied by cap and swaption vols.Why do I keep hearing thats you can't compare the vols in each market?thankstQuoteTherefore a no-arbitrage relationship must be satisfied There is no reason why there should be a no-arbitrage relationship. Liquidity in the two markets is different, you cannot replicate the payoff of a swaption with a set of caps or viceversa (you would need a liquid instrument to trade the correlation between forward rates and all of them), maybe the same players don't participate equally in the two markets. On top of that swaptions are forward settled while caps are not. So lots of different reasons why the two instruments deserve their own volatility dynamic.

Ok, thanks. That makes sense. Not sure why forward setlement would make a dfifference though apart from just being a pain to construct the arb. Would the fact that the caps market uses the forward Libor rate as the underlying state variable for Black Vols while the swaptions market uses forward swap rates, be a factor for different vol surfaces?

As gc says, it ain't "arbitrage", 'cause you can't trade the correlation. At best, it's a relative value trade opportunity. At worst, it's a way to lost all your fingers.