1. Consider the following statement:

One prop trader noted that cap/floor volatility should be slightly higher than swaptions.

Corporates buy caps and investors sell swaptions through callable bonds, said one Londonbased prop trader. The market is structurally short caps and long swaptions.

a. Swaptions are options to get into swaps in a predetermined data, at a predetermined rate.

Explain why, according to this reading, cap/floor volatility should be higher than swaption volatility.

b. What are some plausible reasons for the market to be structurally short of caps and long on swaptions?

c. What would this statement mean in terms of hedging and risk management?