Cap Implied Volatility

An implied volatility is the volatility implied by the market price of an option based on the Black Scholes option pricing model. In cap market, a cap/floor is quoted by implied volatilities but not prices. An interest rate cap volatility surface is a three dimensional plot of the implied volatility of a cap as a function of strike and maturity.

The term structures of implied volatilities which provide indications of the market’s near and long term uncertainty about future short and long term forwar interest rates. A crucial property of the implied volatility surface is the absence of arbitrage.