This is something that hurt me in Sample 2. With regard to interest rate options, why, when calculating the base amount off which the effective interest rate will be computed, do you ADD the cost of puts and SUBTRACT the cost of calls? For example, if you have a loan to be made in 30 days on $1,000,000, you would calculate the FV of a call option you want to buy and subtract it from 1,000,000. The opposite is true with a put, you would calculate the FV and ADD it to the 1,000,000. I don’t understand this at all. Any help is appreciated.
Because, for calls, you’re borrowing money and you paid for a premium, so you effectively get less money, hence the subtractiong (and you’re paying a higher interest because you’ll divide by a smaller number when calculating EAR) The puts are usually from the LENDER’s point of view, where they are lending out the money, and buying a put, so effectively they are lending out more money than the loan amount. So the total money “loaned out” is the actual loan amount and the put premium. hope I explained that ok.