I wonder why option premium is not calculated in effective interest paid or earned at caps and floors on floater? I mean the cost of premium increases effective cost of borrowing or decreases earnings on lending.
IMO, I would calculate the cost of premium in 0th period effective interest, by beginning of agreement.
Also is there any recommended shortcut to remember formulas for Max Profit, Max Loss and BE for all those option strategies? I am trying to derive it in calculations by brainstorming but loosing to much time and feel like my head will burst.
Interest rate adjusted option premium is included in or deducted from the initial loan amount.
e.g
“The cost of the call is $100,000, which is paid on 14 April. LIBOR on 14 April is 5.5 percent.”
“So cash is paid for the call on 14 April. Cash proceeds from the loan are received on 20 August. On 16 February, the loan is repaid and the call payoff (if any) is made.”
“To evaluate the effectiveness of the overall transaction, we need to determine how the call affects the loan. Therefore, we need to incorporate the payment of the call premium on 14 April into the cash flow on the loan. So, it would be appropriate to compound the call premium from 14 April to 20 August. In effect, we need to know what the call, purchased on 14 April, effectively costs on 20 August. We compound its premium for the 128 days from 14 April to 20 August at the rate at which GCT would have to borrow on 14 April. This rate would be LIBOR on 14 April plus 200 basis points, or 7.5 percent. The call premium thus effectively costs”
“$100,000 (1 + 0.075*128/360)= $102,667”
“on 20 August.20 On that date, GCT takes out the loan, thereby receiving $40 mil- lion. We should, however, reduce this amount by $102,667, because GCT effectively receives less money because it must buy the call. So, the loan proceeds are effectively $40,000,000 – $102,667 = $39,897,333.”
This is the initial amount…
Hi CPK, thanks for your explanation. I found that an option premium is calculated and compounded on Add on basis at IR calls and puts but not in subsequent chapter with caps and floors. First, I noticed it in Schweser, then I checked in official curriculum and there is also premium ignored.
In the chapter with IR Puts and Calls it is compounded and then subtracted in the case of call premium or added in the case of put premium on the loan principal proceeds. But same case is not in the next chapter with IR Caps and Floors.
Maybe for those school examples, they just ignored it because it would be too difficult to manually calculate the cost of premium at each period.
We include the future value of the premium for the IR call because its a cost of the loan to a corporation wanting to hedge its short term borrowing costs when they anticipate rates to rise. The FV of the premium is deducted from the loan proceeds giving the corporation less cash flow and thus decreases the loan proceeds (PV) and increases the corporations effective borrowing rate but produces a cap if rates rise enough.
A bank who makes loans in falling IR environments wants to protect the bank’s profitability or its net interest spread buy purchasing protection with an IR put. The bank buys the put thus has a expense or cash outlay as a cost of doing business or cost of the hedge. In this case, the bank does not have that cash to make loans to other borrowers thus it needs to incorporate that expense in the effective borrow cost and is deducted from the loan.
Both IR calls and IR Puts are long or purchased, in both cases the premium paid is carried forward with the time value of money. The IR call is added to the loan cost (PV) of the corporation. The IR put premium is an “opportunity cost” for the bank thus it reduces the amount it could lend.
IR Put Premium - V5 SS15 R27 Section 3.2 look at footnote 22 bottom of page
Marc A. LeFebvre, CFA