Q: 18.2 from Schweser Vol 1, PM Exam # 3

It’s been a long day studying here today so I was hoping that someone could point me in the right direction. Why doesn’t the interest rate call option value have any value and not subtracted from the loan’s interest costs when calculating the effective annual rate? I thought that it’s in the money and you would subtract (.0573-.048)(180/360)* $25M from the loan interest. Have I been at this too long today or am I missing something? Thanks! On a side note, I foudn the morning exam #3 was by far the worst in terms of not representing what the actual past cfai exams were like. It seemed as if the writers got lazy and ran out of question ideas.

the call has value; it is 0.000943443 of the loan amount as pointed out in the paragraph on page 180. that amount times $25mln is and future valued is what you would subtract from your loan amount.

Right, I get that part. It’s when you got to calculate the effective interest rate that I don’t understand why the call’s value isn’t subtracted from the loan’s interest costs.

not the interest cost. its subtraced from the denominator. or $25mln - 0.0000943443*25mln*(90/360). the numerator remains $25mln + 0.63*(180/360)*$25mln

Why doesn’t the numerator change to include the in-the-money interest call option that helps to reduce the loans interest payments? with the exercise rate of 4.8% and the current libor at expiration of 5.73%, why would you subtract: (.0573-.048)x(180/360)X$25M from 25Mx(.048+.15)*(180/360) to determine the interest costs?

Need clarification on what you guys mean by the ‘call’s value’. If you mean the premium, then that is adjusted into the denominator. If you’re talking about the expected payout (which is what I refer to as the ‘value’), then that is adjusted in the numerator.

FlamesFan Wrote: ------------------------------------------------------- > (.0573-.048)x(180/360)X$25M from > 25Mx(.048+.15)*(180/360) to determine the interest > costs? OK! Now you are making sense. You’re SUPPOSED to subtract it, but Schweser essentially told you that since the ending LIBOR rate is above the cap (the call you bought), you are effectively paying the interest on the loan AT THE STRIKE RATE (plus a spread of course). That is why they don’t subtract. The normal way we would do it is: 25Mx(.0573+.15)*(180/360) - (.0573-.048)x(180/360)X$25M

well, you made a mistake to start so this should clear it up: you wrote: “(.0573-.048)x(180/360)X$25M from 25Mx(.048+.15)*(180/360) to determine the interest costs?” your formula should be: "(.0573-.048)x(180/360)X$25M from 25Mx(.0573+.015)*(180/360) to determine the interest costs. but the interest you pay will actually be 0.0573+.015 not 0.048 + 0.015. so your term above is off…your formula should be: I simplify all this…i know that if a call expires in the money we are paying the max amount of interest so…at the max interest you pay that and add that to the $25mln. you know the most interest you pay, in this scenario, is when LIBOR =<0.048. so at libor greater than that, i just do libor + 150bps (or 6.3%)…

that makes sense. thanks!