To calculate the effective exchange rate of a loan + interest rate call, you must first calculate the future value of the interest rate call, and subtract this amount from the amount of the loan. This makes sense to me, because we purchase the call, and should subtract it from the loan we receive.
However, for interest rate puts, we calculate the future value of hte interest rate put, and then add this amount to the amount of the loan. Why would we add the cost of the put to the loan if we are purchasing the put? It seems to me that we should also subtract the cost of the put here as well.
Any help would be appreciated.
i dont know if this is right (still need to review)
if you are combining an interest rate call with a borrowing arrangement :
- you get money from borrowing (+)
- you pay money for call option (-)
It is as if you are borrowing less money because the amount borrowed is reduced by the payment for the call.
if you are combining an interest put with a lending arrangement:
- you lend money (-)
- you pay money for put(-)
It is as if you are lending more money because ontop of the lending arrangement you also need to pay for the put.
I agree with @Alladin.
A floating rate lender purchases the put in order to make sure that he gets at least a certain amount of interest.
So, by buying put in addition to lending the money out,
the total initial outflow for the lender = amount lent + put premium (adjusted for time.
In your calculation of Effective rate, this total outflow should be compared against the total inflow back to the lender.