In Reading 43, the text says that if I decide on Jan 1 to borrow money on June 1 which will be repaid on Dec 31, I can buy an interest rate call on Jan 1 which expires on June 1 and receive the option payoff on Dec 31. My effective interest cost would then be: (Principal Repayment on Dec 31 * 1+Floating Rate of Interest for 6 mths - Option Payoff on Dec 31) / (Principal Borrowed on June 1 - Option Premium Value on June 1) So far, so good. However, they extend the same idea to multiple payments on Pg 414 of Book 5, and calculate the table shows that the effective interest payment is the interest due on each payment less the option payoff. Where is the option price captured in the effective interest rate calc?
You are talking about caps and floors ?? I could not find page 414 in book5.
Yes, I am talking about caps/floors. I have my books in front of me now, so I hope this post helps… Reading 43, Section 3.1 “Using Interest Rate Calls with Borrowing” Pg 400 of the Level 5 CFAI txt, the call is purchased on Apr 14, expires on Aug 20 and payoff is on Feb 16. Therefore the cost of the call is deducted from the amount borrowed on Aug 20, (the $40,000,000-$102,667=$39,897,333) and is thus part of the effective interest calc. When the same concept is extended to floating-rate loans, I don’t see where the cost of the option is captured in the effective interest calc. The example I was referring to in my previous post was from Reading 43, Section 3.3, Example 13. The effective interest calculation (Interest Due-Caplet Payoff) of $613,542 on Jul 14 doesn’t include the cost of the caplet.