In the OTC market options on short rates are called caps and flaws.
This naming convention comes from the use of these options by hedges to either cap the interest rate they are paying, for example, on a loan, or put a floor under the interest they are receiving.
For example, on a floating rate note, we don't use the call and put names in OTC interest rate options, but caps are call options and flaws are put. Options on the underlying interest rate caps and flaws are actually made up of individual options called caplets and flaws, which are the options on each short rate.
For example, a five year cap, which offers protection against three month arrival going higher will contain quarterly caplets one for each three month your IO fixing.
Each caplet operates independently and produces a payoff.
If your IO fixes above the strike as call options do, this payoff is multiplied by a day count fraction because we want a payoff, which is pro ratted for the interest period to which it applies.
Payoffs for caplets and flaws are cash settled at the end of their interest periods.
A cap is simply the linear combination of all the constituent caplets and tends to be traded as one product.
The price of the cap is the sum of the prices of the individual caplets.
The same is true for flaws and flaws.
Note we have two alternative methods to trade options on short rates, exchange traded stir options, and OTC traded caps and flaws.
The type of user tends to differ with caps and flaws being mostly preferred by hedges, who can create a bespoke hedge to a given asset or liability, and stir options being traded by speculators and market makers who prioritize the liquidity of these standardized contracts.
