Party A commits to lending to Party B in 6 months and wants to protect itself from rates decreasing and buys a interest rate put.
When calculating the effective interest rate on the loan, why is the put’s premium effective cost calculated using the loan’s spread, f.ex Libor+200bps. Why not just risk free rate?
Its like the units you measure your lending rate. Therefore “effective lending rate”
Yeah I understand that, hence I wrote Libor+200bps as an example. I was asking for the logic behind adding the spread to Libor.
You add the spread because that’s the cost of borrowing or lending.
I think that makes sense when you’re borrowing and using calls to protect your positio but with lending and puts my logic says that the opportunity cost is just the libor. Oh well, will just have to memorize that.
When you’re lending, the opportunity cost is libor + spread because that is what you would lend to someone “L + 200bps".
No, your lending rate is not set in stone. It depends on the counterparty. If you’re lending to a AAA country you lend at prettty much the risk free rate, if you lend to some firm in financial difficulties you lend at like libor+1000bps.
Thats why the spread matches the lending rate of the person you are lending to.
On your logic of using just libor for opportunity cost… you’re assuming the opportunity is perfect credit? Or assuming the opportunity is zero?
yeah you’re right, that doesn’t really make sense.