Hello. This question is about direction of the payoffs with caps and floors.
risk management page 324-325. The floor is PURCHaSED. The May 5th libor is below the strike causing a payoff at the next reset date. This payoff INCREASES the effective interest.
Page 326-327. The next example the investor SELLS the floor. Then the libor goes below the strike, the payoff again INCREASED the effective interest.
I would have thought the payoff in first example would have decreased the effective interest. Can someone please explain why?
I am confused too. In the CFA mock question 40 PM . Another of Mamani’s clients, Arequipa Industries (AI), is about to borrow PEN120 million for two years at a floating rate of 180-day Libor (currently 3.25%) plus a fixed spread of 90 basis points with semiannual resets, interest payments based on actual days/360, and repayment of principal at maturity. AI’s management is worried that Libor might rise during the term of the loan and asks Mamani to recommend strategies to reduce this risk. Mamani suggests a zero-cost collar on 180-day Libor with a cap of 4.70% and a floor of 2.25%, payment dates matching the loan payments (on 30 June and 31 December, with the first payment on 31 December), and interest based on actual days/360. She develops various examples of the collar’s impact, including one using the interest rate scenario in Exhibit 1. 40. Using the Libor scenario shown in Exhibit 1 and under the assumption that the zero-cost collar is put in place, the effective interest due on AI’s loan for the semiannual period ended on 31 December 2013 is closest to: A. PEN1,911,000 B. PEN1,365,000 C. PEN2,062,667 the guy purchesed zero collar and the LIBOR was bellow floor. So I don’t know why the borrower should excersie the option and pay more ? The interest rate already declined ???
I got it I guess. The zero cost collar is not necessarily sell call buy put . Here he expected interest rate to rise so he should buy cap and sell floor and he screwed and interest rate declined and the buyer of the floort excecised the option. Good point hope it show on the exam.
In the first example I am a lender. I buy an interest rate floor to protect against declines in interest rates. Effective interest is paid to me. The floor provides higher effective interest paid to me than would have been without the floor.
In the second exmaple I am a borrower so I am paying effective interest. If rates go up I get hurt. I didn’t read the full example, but selling a floor earns me a premium if the reference rate does not go below it. If it does then I will end up paying the effective interest plus the payoff to the floor holder. If I had not written the floor I would have paid less effective interest.
again the answer for Q40 I guess is wrong ? This is the equation used in the answerLoan balance × (Actual days in period/360) × [Libort1 + Spread + max(0,Libort– 1 – Cap rate) + max(0,Floor rate – Libort–1)… Why they add the cap payoff even though he is borrower. ? MR. Chuck . ?
I think there is an error in the formula. They should be subtracting the cap payoff and not adding it. The answer should still be A because the cap is never in the money so the +/- sign is a non-factor. They created a zero cost collar so they have to be short one leg and long the other.
Because they are a floating rate borrower a zero cost collar they should buy a cap and sell a floor. Effective interest paid should be the NP x (Days/360)(reference rate - cap payoff + floor payoff).