If a firm borrowed 10m and the borrowing rate is LIBOR + margin. Lets say current LIBOR is 3.8% and the firm buys an interest rate call with a strike rate of 4%. In this case, the firm will not exercise the call since current LIBOR is less than 3.8%, yet the answer is worked out with the 4%. Any thoughts?
payoff of the interest rate call is paid on the next reset date, so the previous libor must have been taken…
The firm will exercise if the reference rate (LIBOR) is greater than the 4% strike. If it’s a European option, only compare rates at expiry, but if American can be exercised anytime up to expiry if the economics and expectations make sense. Unlike caps, there is no reset period though-only settlement at exercise date or it just expires and the premium is lost (or could be sold prior to expiration to try to recoup some lost premium). Sounds like some info is missing OP.
Correction - settlement date may be some future date if exercised prior to expiry, though expiry is usually when the funds will be borrowed. In either case, settlement will be at the time of borrowing, regardless of when the option is exercised, I believe. I think the question will state that…not 100% on that though so if anyone can confirm that would be great.
Thank you for confirming.