Let's now explore what happens if we have caps and flaws on the new risk-free rates such as sofa or soya.

The answer is that they largely work the same as caps and flaws on eyeballs, except the pale fed expiry is based on the average of the RFR rate over the interest period, usually calculated as a compounded average.

This is the so-called backward looking rate, which is calculated on, for example, RFR swaps, the extra complications.

The springs are twofold.

Firstly, all RFR Caplets and flaws now have a longer time to expiry because the RFR term rate is known at the end of the period rather than the start.

Secondly, the options pay off versus an average rate over the interest period, so they become average rate or Asian options instead of Europeans.

This makes the pricing slightly more complex and possibly unat attractively more opaque to less sophisticated hedges.

If a hedger has a liability or asset, which has a payment linked to a term RFR rate, such as term sofa, then they will need to hedge with a capital floor, which references that term RFR rate.

Term RFR. Caps and floors operate the same way as your rib caps and floors with a single fixing of the rate at the start of the period.