"Of course"

CFA Level III
#1

I admit my brain is probably fried worse than KFC, but I am not able to follow why CFAI text says “of course a little more than…” in the examples in volume 5 pages 407 (example 11) and 413 (example 12).

“Of course, a little more than 100 basis points of this amount is the spread.” They are referring to how borrowers and lenders get the various different rates by buying interest rate calls and puts, respectively, when taking out or making LIBOR-based loans. E.g. the quote comes from example 12 where a lender can lend at LIBOR + 100 bp. So what’s with the “little more than…” part?

#2

Anyone? Bueller?

#3

I wish that I had the curriculum so that I could reply sensibly to this.

#4

you started at day 0, counted up the call premium to day the loan was taken out … at the LIBOR from the day you took the call option.

Then you calculate a EAR number for the period of the loan and calculate a annual EAR.

The spread on the loan / borrowing = LIBOR + Spread.

In the End when the Call is in the money - EAR = a little more than that. e…g when LIBOR was 6%, 3% spread and you had a ending EAR of 9.25%…

#5

Thanks CP. This can probably wait till after the exam , but I have a little problem with CFAI saying “of course”. It’s not obvious to me why the actual spread should exceed theoretical spread (I understand it does.)

S2000,

these are the examples where a borrower buys an interest call option by paying a premium P, to protect against a rising rate for a LIBOR + spread loan. (Or a lender buying an interest rate put to protect against falling rates on a floating rate loan.)

I am guessing it’s something like this: If the loan is L, call premium is FV§ on the day of the loan, so the effective loan amount would be L - FV§. If rates rise, it will guarantee a rate = LIBOR + S, but the principal amount is less by FV§, so the effective rate is slightly more than LIBOR + S. (Similarly for the put where the effective loan amount is L + FV§ and rates fall.)

#6

1recho

“Of coarse, a little more than 100/300 bp of this amount is the spread”

Here CFAI is referring to the spread calculated from the effective rate shown in the calculation

The effective rate, in example 11 is in the first case say, is 9.25% or .0925. This is the case when LIBOR is 6% on Feb 15. Now, we should expect to lock the 300bp based on the call we just purchase on excercise rate of 5%.

However, you will notice that the actual spead is 325bp (9.25-6.00) as opposed to 300bp we locked.

Therefore the cirriculum says the spread in effect is “a little more than” in this case 25bp that 300, due to the call premium.

hth