A Practical Guide to Strip Caplet Volatilities

Abstract

We study caplet stripping, the problem of recovering a caplet volatility term structure consistent with quoted cap volatilities. Many academic papers on the Libor market model assume caplet volatilities are readily available, whereas practitioners know they are not and extracting them is a complex task. This paper presents a practical workflow, structuring the presentation around a constructive algorithm. We start with criteria on the input data based on cap time-value monotonicity. If time values fail this check, we show how to correct the quotes using robust outlier detection based on the modified Z-score. The time-value proposition naturally leads to a direct non-bootstrap stripping approach by interpolating cap time values, which yields arbitrage-free caplet volatilities by construction. We then revisit the classic sequential bootstrap approach. We introduce compact-kernel transition interpolants (flat-linear and $C^1$ flat-smooth) that preserve bootstrap equivalence. Finally, for a richer, smoother curve, we introduce global search methods using midpoint node placement with positivity-preserving calibration. Pathological cases and detailed analyses of oscillations are provided in the appendix.