Consider a swap, a cap and a floor with the same characteristics (i.e. the same floating interest rate, strike (or fixed) interest rate, notional, and payment dates). The fixed interest rate is exogenously given; it is not necessarily equal to the fair swap rate.

i) Derive a no-arbitrage relationship between the values of these three financial instruments.

ii)Comment on the case where the fixed interest rate is equal to the fair swap rate.

iii) How do the relative values of the swap, cap and floor change if the yield curve shifts upwards? Explain your answer.

Answer rating: 100% (QA)

Arbitrage pricing theory APT is an alternative to the capital asset pricing model CAPM for explaining returns of assets or portfolios It was developed by economist Stephen Ross in the 1970s Over the y... View the full answer