A Term Structure Model and Interest Rate Options
Closely related to option contracts over stocks are interest rate options like caps and floors which offer the possibility of protection against unfavorable interest rate movements. The properties of interest rate options are similar to those of European call and put options over debt contracts. In principle we are looking for a protection against upward movements of the interest rate, called a cap contract and for protection against downward movements, which is known as a floor contract. The underlying security of these contracts is the interest rate (e.g. 3 months USOR).
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