Schweser Book 1, Exam 3PM, Question 93… If 1-year LIBOR at the end of year 2 is 5.8%, the absolute value of a position (long or short) in the 2-year, 6%, 30,000,000 interest rate floor at the end of year 2 is closest to: a) 56,711 b) 60,000 c) 63,480 Answer is A. The explanation makes NO sense to me… “The floor pays off in arrears, so the $60,000 payoff is made at the end of the 3rd year, and the floor value at maturity is the present value of the $60,000 payoff discounted 1 year at 5.8%.” WTF are they talking about with this “3rd year” and paying in arrears. WTF!!!
it is a 6% floor. LIBOR at the end of the 2nd year is 5.8%. Difference between 6% and 5.8% discounted at 5.8% will be the Floor’s payoff in the 3rd year. The 5.8% at the end of the 2nd year - is applicable to payoff in the 3rd year. 30 Mill * (0.06 - 0.058) / (1.058) = 56710.77
This will come up in various places…just remember that 1-year LIBOR means you get the payment 1 year from now.