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I wanted to know the difference between a caplet and a call. In my course (Interest rate models and curves) , we said that a caplet is a call option. Is it really true? Thanks

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up vote 1 down vote accepted

A caplet is a call, as the payoff is given by $(L-K)^+$, where $L$ is the libor rate for a given calculation period and $K$ is the pre-agreed rate. However, in practice, the volatilities for a strip of caps are usually provided, and then a bootstrapping algorithm is needed to back out the volatility for each caplet.

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There is a lot of interest in Caps and how to price them. Some clever people said I have an idea, we could break the Cap up into things we'll call Caplets and those are a kind of Call option, which we understand already. That is how mathematicians work, always trying to reduce the problem to an already known case. That's how Caplets came about. – noob2 Nov 5 '15 at 22:20
@noob2:You said what I want to say, but did not know how to say. – Gordon Nov 6 '15 at 2:06

Call option gives the exercise strategy, but it doesn't actually tell you anything about the underlying. It could be a stock, a LIBOR interest rate, a bond or any tradable asset.

The simplest call option would be an equity call option, where the underlying is a stock. In a caplet, the underlying is the forward interest rate (eg: LIBOR), you would exercise a caplet if the interest rate at maturity is more than than the rate specified in the option contract.

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