There is probably a simple concept I am forgetting but when we calculate the FV of the option premium to the date of the loan in an interest rate option
Why do we do
premium*((1+interest)*(maturity/360))
Instead of
premium*(1+interest)^(maturity/360)
I thought the second way (with the exponent) is how you compound interest. What am I missing?
It’s because we use LIBOR, which are annualized rates. When un-annualizing them we use a simple interest and 360-day convention.
What you really mean is that LIBOR is quoted as a nominal rate, not an effective rate.
So that’s why it is manipulated so often…
The formula should be Premium [1 + (nom rate)(maturity/360)] Premium [1+(1+effective rate) ^(maturity/360)-1]