Interest Rate Option Payoff/EAR

Does anyone have any advice or logic which can help me understand this better? It’s really challenging me and I just can’t seem to get it. Militant repetition until exam day?

Only Legends Can Interpret Everything

O. L. C. I. E

O = option Cost … The premium x t x the days till the loan starts over 360

L = Loan Amount … The full Loan - the Option cost (Above)

C = Call Payoff… (R-X) x t x Full Loan

I = Interest… R used in call above + Libor x loan x t

E…Effective Rate… = Loan + Int - call payoff / L (above)… take all of that and put it to the root of 365/t

Some points to make it easier:

  1. USUALLY T in the “O” will be different to T in the C & I. (C & I are always the same)

  2. If it is a put , then you ADD option cost at L, and you ADD option payoff at E…

Follow the acronym above and try the Blue Box again, note that they do a slightly different order, but I prefer calculating the order above - plus the acronym sticks with me.

remember the components and everything should make sense.

these are:

1)future value of option premium 2) interest payable/receivable assuming no option 3)option payoff 4) notional principal

if you’re borrowing, EAR is what you pay/what you receive and adjusted to an annual rate

if you’re lending, EAR is what you receive/what you pay and adjusted to an annual rate

if you’re borrowing, reduce future value of option premium from the principal as what you receive

if you’re lending, add future value of option premium to the principal as what you pay

the numerator is always interest without option + option payoff + notional principal in both borrowing and lending cases.

Rex, you the man.

I do / remember 4 main things:

  1. Draw a timeline - t(0)____t(t)_____t(T) [t is the point when you exercise the option, pay back the premium and the loan starts]

  2. LIBOR is determined at the start of the period [re the calc for the payment at 18 months, use LIBOR at 12 months]

  3. Unless stated (which I’ve never seen), the option value looks at (floor or cap) vs LIBOR, not vs LIBOR + X bps.

  4. LIBOR is 360, EAR is 365.