 # Option Premiums on Interest Rate Caps/Floors

Anyone else having difficulty factoring in the option premiums on interest rate caplets/floorlets? On the two blue box examples on pages 448-451, I do not see how the option premium is factored into the effective interest calculation like it is for the standard single period options where it is deducted for the effective interest rate.

I know in the end-of-chapter summary it says it is paid at the beginning but do you think we need to know any calculations on how to factor that into the payoff? If so, please share how that is done.

I don’t see the caplet or floorlet premium being used at all in the solution . It would not be shown in the cap/floorlet payoff , only in the effective interest rate. The text show the effective interest , _ in dollars _ , which is what the borrower and some option counterparty are paying the bank . It does not show the effective interest rate which the bank receives ( because that is a cash flow calculation involving the premium cost and borrower plus option payoffs )

Did the LOS say something about calculating the caplet/floorlet issues(interest due,effective interest) except for payoffs?

…I dont have the book with me right now but i think we only need to calc the payoffs

thx

Alladin - yeah you may be right that we don’t need to do anything with the premiums if we are just calculating the interim period payoffs.

From the LOS - calculate the payoffs for a series of interest rate outcomes when a floating rate loan is combined with 1) an interest rate cap, 2) an interest rate floor, or 3) an interest rate collar;

However, I wasn’t sure if the first or last period must factor in the cost since they made it a point to include the option premium as a variable in all the examples. Why even include it??

CFAI way , contrive to confuse and confound

“From the LOS - calculate the payoffs for a series of interest rate outcomes when a floating rate loan is combined with 1) an interest rate cap, 2) an interest rate floor, or 3) an interest rate collar”

Calculate PAYOFFS, not Effective Annual Rate. That would be a much larger calculation involving discounting each payoff over multiple years back to the start of the contract. You can’t even calculate it at the beginning of the contract because you wouldn’t know the periodic interest rates until the last caplet/floorlet. At that time it becoms more of a operational check to make sure you made money from the position rather than an investment decision.