# BK 6 Exam 3 PM - Q 94

Aight AF, took the day off to isolate myself in a library. This Q drove me nuts if anyone could explain I’d appreciate it. I’ll let y’all take a crack before I post the solution, unless you feel like peeking. Question: Reichmann is analyzing the possibility of using interest rate caps and floors as well as interest rate options and options on fixed income securities, to hedge the interest rate risk of his overall portfolio. Reichmann uses a binomial interest rate model to value 1-year and 2-year 6% floors on 1-year LIBOR, both based on \$30mm principal value with annual payments. He values the 1-year floor at \$90,000 and the 2-year floor at \$285,000. Based on the results from Reichmann’s binomial interest rate model, the value of a 2-year, \$30 mm European put option on LIBOR with a floor strike of 6% is closest to: A. \$185,000 B. \$195,000 C. \$270,000 D. \$375,000

i got it wrong… is it just the \$285,000 and it’s closest to \$270,000?.. these closest answers drive me nuts. are they supposed to be really close or not?.. .or do you discount on period by some interest rate that isn’t given??.. schweser site has the answer.

Ya, I still couldn’t figure out what they meant. I thought you add the values of the floors so I was way off. I don’t expect to see a q like this anyways I was just spinning my wheels on it.

The answer is ‘B.’ And I’m gone.

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floor is combo of floorlets… so (lol) you subtract first year from second year (Because i see the answer)… ok, i still can’t get it having seen the Q twice and the answer twice… waiting for schweser site right now.

i still haven’t seen the answer again yet. but the floor is a one year and two year european option. it’s two options. you get a payout each year… so if you take a floor for two years and one for one year, you take the difference and that’s your two year euro option… no discounting or anything (assuming he’s right about B, and i think he is from memory). anyway i was lost on exam and lost even after seeing Q and answer twice. but it now makes some sense.

mwvt9, from the quant section to the end of this exam (85-108 range) I found a bunch of questions that would have surprised me. Might be worth a quick breeze through with the solutions.

Thanks west, it’s becoming clearer and it is B according to the back of the book, I don’t have the detailed solutions with me…

yeah, the book said exactly what i said (and as i said, i’d seen Q and A twice and still didn’t remember). if you had floor on ibm stock, you’d get payment at end of first and second year if it was below strike. whereas normal option, if you exercised after first year, then no more option. so the floor is two options - a one year and a two year one and they are separate. very confusing…

1 year floor = 1 year european put option on rates --------(I) 2 year floor = 1 year put + 2 year put - (II) …(series of put options) so . 2 year put = 2 year floor - 1 year put which is then same as 2 year floor - 1 year floor important to understand (I) and (II)

Just to clarify, and maybe everybody has this down, but: It’s two floors - a one year floor and a two year floor. The one year floor is made of a one year put option and the two year floor is made from the combination of a one year put option and a two year put option. So if you want the value of the two year put option alone, you take the two year floor minus the one year floor. WestBruin was right there, but I didn’t see anybody make the distinction that their are two floors that we are looking at here.

Ahh, there it is! Thanks Dsylexic and westbruin.

ozzy, i think technically it’s two floorlets and one floor… and i didn’t have that in earlier explanation.

westbruin Wrote: ------------------------------------------------------- > ozzy, i think technically it’s two floorlets and > one floor… and i didn’t have that in earlier > explanation. don’t think so. It’s technically two floors, one of which has two floorlets, one of which is basically a straight european put (or one floorlet).

ozzy609 Wrote: ------------------------------------------------------- > westbruin Wrote: > -------------------------------------------------- > ----- > > ozzy, i think technically it’s two floorlets > and > > one floor… and i didn’t have that in earlier > > explanation. > > don’t think so. It’s technically two floors, one > of which has two floorlets, one of which is > basically a straight european put (or one > floorlet). ok, thanks… i’ll have to check this in next couple of days…