How are caps quoted in the market?if today was 12/31/03 thena 5y x 1y cap is a forward starting cap(starting in 5 years ..so 12/31/08) ona series of 4 quarterly reset caplets?Is the underlying reference rate always3mos libor?Can someone give me some background inthe institiutional aspects of plain vanilla caps?I apologize if my question is both naive and vague.Cordially...

In a spot-starting cap there will always be one less caplet than the term of the cap would otherwise indicate. For example, a 1-year spot-starting quarterly cap will have 3 caplets, the first staring in 3 months. This is because the rate for the first 3-month period starting today is already known (just 3-month cash). A forward-starting 1-year quarterly cap will have 4 caplets, and so on.Being an OTC instrument, all terms are negotiable, but a large majority of USD caps use 3-month LIBOR as the rate index. This is because liquidity Eurodollar futures and futures options can be used as hedge instruments.Caps tend to be quoted “at-the-money”, which is interesting since the forward rate for each component caplet is likely different unless the yield curve is flat. An ATM strike for a cap is actually the fixed rate on a par swap with equivalent terms (someone correct me if I’m wrong or didn’t state this correctly).Caps also tend to be quoted with a single yield volatility number, which you can interpret as the constant volatility applied to all caplets which results in the observed market price for the cap as a whole. In practice, many people strip out individual caplet vols from a set of cap quotations using a procedure similar to bootstrapping the zero curve and price caps as portfolios of caplets, each with their own vol.

So , e.g. if we have a 2 year cap quoted ATM with semi annual resets, then this means the strike for each constituent caplet is the current 2 year par swap rate with semi-annual payments?

QuoteOriginally posted by: DreamerSo , e.g. if we have a 2 year cap quoted ATM with semi annual resets, then this means the strike for each constituent caplet is the current 2 year par swap rate with semi-annual payments?nope, it is actually par rate on a Q/Q swap. strange but true. note that all this is US/libor conventions

QuoteOriginally posted by: OdiseasHow are caps quoted in the market?if today was 12/31/03 thena 5y x 1y cap is a forward starting cap(starting in 5 years ..so 12/31/08) ona series of 4 quarterly reset caplets?.No, this is not how they are quoted. The cap that you describe would be a "five by six". Unlike swaptions, where you quote expiry-tenor, caps are quoted as start - end.If they are starting spot, they are simply called by their end date.I also disagree with Slevin on the meaning of "ATM" in caps. The ATM rate that I quote is the swap rate for the swap that matches the cap. So if the cap is quarterly, I'd quote the equivalent Q/Q mm swap rate. If the cap was a 1year cap, I'd use the 9m rate 3m forward, Q/Q mm.As has been pointed out below, the conventions in OTC options are generally not strong enough that you can trade without agreeing terms with the counterparty. There are often disagreements about roll dates, start dates, end dates, strike, and even settlement methods. Often people will ask for a cash settled swaption in EUR, and think that the payment at the end is from a par curve, and not using a flat discount factor. I have actually had to speak to cliebts who thought I was riping them off because they;d based all their calculations on the wrong DV01 calculation.It gets worse when people ask for packages, and describe it as "DV01 Neutral", or "Vega neutral". People sitting on different continents tend to have quite different ideas about what these mean.

QuoteOriginally posted by: NorthernJohnIf the cap was a 1year cap, I'd use the 9m rate 3m forward, Q/Q mm.Q/Q par rate, all USD/Libor (ACT/360, F, Adj) - isn't that what i said?

QuoteOriginally posted by: slevinQuoteOriginally posted by: NorthernJohnIf the cap was a 1year cap, I'd use the 9m rate 3m forward, Q/Q mm.Q/Q par rate, all USD/Libor (ACT/360, F, Adj) - isn't that what i said?You said that on a semiannual cap, "nope, it is actually par rate on a Q/Q swap. strange but true. note that all this is US/libor conventions "It's this bit that's incorrect. We quote the ATM rate on a semiannual swap if it is semiannual resets, or on a monthly swap if it is monthly resets.The ATM rate is only the q/q swap if the cap is quarterly.

QuoteOriginally posted by: NorthernJohnQuoteOriginally posted by: slevinQuoteOriginally posted by: NorthernJohnIf the cap was a 1year cap, I'd use the 9m rate 3m forward, Q/Q mm.Q/Q par rate, all USD/Libor (ACT/360, F, Adj) - isn't that what i said?You said that on a semiannual cap, "nope, it is actually par rate on a Q/Q swap. strange but true. note that all this is US/libor conventions "It's this bit that's incorrect. We quote the ATM rate on a semiannual swap if it is semiannual resets, or on a monthly swap if it is monthly resets.The ATM rate is only the q/q swap if the cap is quarterly.oops, i did not read the actual question and thought that we are talking default market quotes, which are quaterly. my bad, your good.

So to clarify, my suppposition was true?Thanks

QuoteOriginally posted by: DreamerSo to clarify, my suppposition was true?ThanksYes, as long as you remember to have the correct day count basis on both legs of it.

Thanks againOh, commiserations about the boat race, better luck next year...

QuoteOriginally posted by: DreamerThanks againOh, commiserations about the boat race, better luck next year...Did Oxford lose?I am totally removed from UK life over here, so hadn't realised. Was it a crushing defeat?

Well, yes, it was a big margin of victory for Cambridge, but the race was marred by an early clash, which, to some extent, was the fault of the Oxford Cox. The Oxford Bow man came off his seat, and missed about 3 strokes.Other than that, it did seem Cambridge were the faster crew, as they were able to maintain their lead, and even extend it while rating about 5 strokes a minute less then Oxford.Didn?t really enjoy winning as much because it very quickly became a bit of a procession.