CFA Level II Exam · Valuation and Analysis of Bonds with Embedded Options

How to Value Capped and Floored Floating-Rate Bonds

Updated 7 October 2026 · Fact-checked

A capped or floored floating-rate note is valued as a straight FRN plus or minus embedded options. A cap limits the coupon, so the investor is short a series of caplets: capped FRN = straight FRN − caplets. A floor sets a minimum coupon, so the investor is long floorlets: floored FRN = straight FRN + floorlets.

Understand Valuing Capped and Floored Floating-Rate Bonds

A straight FRN pays a coupon equal to a reference rate plus a quoted margin. Its coupon resets each period, so its value stays close to par at reset dates when the margin matches the required spread.

A capped FRN sets a maximum coupon. If the reference rate rises above the cap, the investor still receives only the capped rate. The issuer benefits from this limit. So the investor has effectively sold the issuer a series of interest rate call options on the reference rate. Each option covers one coupon period and is called a caplet. The cap is the set of caplets.

A floored FRN sets a minimum coupon. If the reference rate falls below the floor, the investor still receives the floor rate. The investor benefits, so the investor has bought a series of interest rate put options on the reference rate. Each one is a floorlet. The floor is the set of floorlets.

The logic is simple. Start with the straight FRN. Then adjust for the option. The investor is short caplets in a capped FRN, so the bond is worth less than the straight FRN. The investor is long floorlets in a floored FRN, so the bond is worth more.

In an item set, you will usually be given the straight FRN value and the caplet or floorlet values, often from a binomial interest rate tree or the Black model. Your job is to pick the right sign and add up all the option values for the right periods.

Key formulas to remember

Capped FRN value: Capped FRN = Straight FRN − Σ Caplets; The investor is short the caplets. The issuer holds the cap. Value falls versus the straight FRN.
Floored FRN value: Floored FRN = Straight FRN + Σ Floorlets; The investor is long the floorlets. Value rises versus the straight FRN.
Cap and floor together (collar): Collared FRN = Straight FRN − Σ Caplets + Σ Floorlets; Use this when the note has both a maximum and a minimum coupon.
Caplet payoff (per period): Notional × max(0, reference rate − cap rate) × period fraction; Paid at the end of the period, with the rate set at the start. Discount it back to today.
Floorlet payoff (per period): Notional × max(0, floor rate − reference rate) × period fraction; Paid at the end of the period, with the rate set at the start. Discount it back to today.

How to solve Valuing Capped and Floored Floating-Rate Bonds questions

Use the same sequence for any capped or floored FRN question in a vignette. The work is mostly choosing the right sign and the right values.

1Identify the note: straight, capped, floored, or both. Read the coupon formula for the cap or floor rate.
2Find the straight FRN value in the vignette. If it is not given, it is often close to par at a reset date when the margin equals the required spread.
3Decide who holds the option. A cap benefits the issuer, so the investor is short caplets. A floor benefits the investor, so the investor is long floorlets.
4Find the option values. Check whether they are per period or already summed across all periods, and whether they are already per ₹100 or per unit of par.
5Apply the sign: subtract caplets for a capped FRN, add floorlets for a floored FRN. For a collar, do both.
6Check the units. Make sure the option values and the bond value are on the same par basis, such as per 100 of par.
7Sense-check: a capped FRN must be worth less than the straight FRN, and a floored FRN must be worth more.

Quickest way: Sign check in ten seconds

When to use it: Use this when the vignette already gives you the straight FRN value and the caplet or floorlet values, and the question asks for the note value or the value of the cap or floor.

Cap means the value goes down. Floor means the value goes up.
Write the one-line formula: straight FRN − caplets, or straight FRN + floorlets.
Add up all the caplets or floorlets across the periods before applying the sign.
Check your answer against the straight FRN. If a capped value is above it, or a floored value is below it, you have the sign wrong.

Common mistakes in Valuing Capped and Floored Floating-Rate Bonds

Adding caplets to the straight FRN value for a capped note.
Candidates see an option and assume it adds value. They forget the investor is the seller of the cap.
Fix: Ask who benefits. The issuer gains from the cap, so the investor is short the caplets. Subtract them.
Subtracting floorlets from the straight FRN value for a floored note.
Candidates apply the capped rule to both notes by habit.
Fix: A floor protects the investor. The investor is long floorlets, so you add their value.
Using only one caplet or floorlet instead of the full set.
The vignette may show a single period in an exhibit, and candidates stop there.
Fix: The cap or floor is a series of options, one per coupon period. Sum every period that the note covers.
Confusing caplets with puts and floorlets with calls on the reference rate.
Candidates think about bond prices instead of interest rates.
Fix: A caplet is a call on the reference rate and pays when rates rise above the cap. A floorlet is a put on the rate and pays when rates fall below the floor.
Mixing units, such as a caplet value per ₹1 of notional with a bond value per ₹100.
Exhibits sometimes show values on different bases.
Fix: Convert everything to the same par basis before adding or subtracting.

Worked examples

Example 1

A vignette describes a 3-year capped FRN that pays the reference rate plus 0.50%, with a cap on the coupon. A straight FRN with the same terms is valued at 100.00 per 100 of par. The three caplets embedded in the cap are valued at 0.40, 0.65 and 0.85 per 100 of par. Q1: Who holds the cap? Q2: What is the value of the capped FRN? Q3: A floored version of the same straight FRN has three floorlets worth 0.30 in total. Is the floored FRN worth more or less than the straight FRN?

Show the solution

Q1: The cap limits the coupon the issuer pays. The issuer benefits, so the issuer holds the cap and the investor is short the caplets.
Q2: Add the caplets: 0.40 + 0.65 + 0.85 = 1.90.
Capped FRN = 100.00 − 1.90 = 98.10.
Q3: A floored FRN is the straight FRN plus the floorlets: 100.00 + 0.30 = 100.30. That is more than the straight FRN.

Answer: Q1: The issuer holds the cap. Q2: 98.10 per 100 of par. Q3: The floored FRN is worth more, at 100.30.

Example 2

A 2-year floored FRN pays the reference rate plus 0.80% with a minimum coupon. The straight FRN is valued at 101.20 per 100 of par. The two floorlets are valued at 0.35 and 0.55 per 100. Q1: What is the floored FRN value? Q2: What is the value of the floor to the investor? Q3: If a cap with caplets worth a total of 0.70 were also added, what would the collared FRN be worth?

Show the solution

Q1: Sum the floorlets: 0.35 + 0.55 = 0.90.
Floored FRN = 101.20 + 0.90 = 102.10.
Q2: The floor is the sum of the floorlets, which is 0.90 per 100 of par. The investor owns it.
Q3: Collared FRN = straight − caplets + floorlets = 101.20 − 0.70 + 0.90 = 101.40.

Answer: Q1: 102.10. Q2: 0.90 per 100 of par. Q3: 101.40.

Exam tips

Memorise the two signs first: capped means minus caplets, floored means plus floorlets. Most marks here are about the sign.
Read the vignette for who holds the option. Questions sometimes ask from the issuer's view, which flips the sign of the effect.
Sum every caplet or floorlet period before you subtract or add. Check whether the exhibit already gives a total.
Do a quick reasonableness check against the straight FRN. It catches sign errors in seconds.
There is no penalty for wrong answers, so never leave a question blank, but use the sign rule to eliminate options first.

Valuing Capped and Floored Floating-Rate Bonds: frequently asked questions

How do you value a capped floating-rate bond?

Value a straight FRN with the same terms, then subtract the value of the embedded caplets. The investor is short the cap, so the capped FRN is worth less than the straight FRN.

What is a floorlet in a floored FRN?

A floorlet is one period's put option on the reference rate. It pays off when the reference rate is below the floor rate. A floor is a series of floorlets, one for each coupon period, and the investor owns them.

Why is a capped FRN worth less than a straight FRN?

The cap limits the coupon the investor can receive when rates rise. That limit has a cost to the investor, equal to the value of the caplets. The investor gets less upside, so the bond is worth less.

Do I need to compute caplet values in the exam?

Usually the vignette gives caplet or floorlet values, or a binomial tree or Black model inputs. Read the question carefully for what is asked. Often you only need to apply the correct sign and sum the values.