Why is it that when they calculate the interest on the loan, they don’t subtract the payoff from the call option. They say that LIBOR at expiration is 5.73% and the call option had an exercise rate of 4.8%, then wouldn’t the pay off be: 25mil (.0573 - 0.048)180/360 = 116,250. This would then be subtracted from the interest on the loan: 25mil (0.048+0.015)180/360 = 787,500, making the effective interest of 787,500 - 116,250 = 671,250. For some reason they didn’t subtract the payoff from the Option when they calculated the interest. Did I miss something?
Don’t have the question in front of me… One of the way you can do this is to use the strike price to figure out the interest payment if the LIBOR at expiration is higer than the strike price (given it is a call options) since that is the max. interest payment you have to make.
So in this case where the strike price is 4.8% and the LIBOR at expiration is 5.73%. Wouldn’t the payoff to the holder of the call option be 5.73-4.8 and that would offset my interest costs? Have I been studying too hard and missing something here???
I think I know what’s going on here. There is one other effective interest rate question like this in one of the Schweser exams. In the Schweser answer to that one they take the interest without the call and then subtract the interest savings from the call. In this question, Schweser’s answer cuts that step out by just showing the effective interet rate, but either way it’s the same answer because: libor rate - (libor - call rate) = call rate
^yes, you can do it that way too. Let’s say you normally borrow at LIBOR+1, your option strikes at 5%, at expiration, LIBOR is 6%. You can do one of the two ways, 1). Find out interrest payment for 6+1=7%, then find out option payoff (6-5), net them, calculate your total EAR. 2). Because you are long the call, your effective max. borrowing rate will be at 5+1 (5% is the strike price). So, just calculate the interest payment for 5+1=6%, forget about the payoff part. You will get the same result!! Promise. Make sense??
Yeah…thanks, got it now. My problem was that when I was calculating the the interest on the loan, I incorrectly used the original LIBOR and not the LIBOR at expiration. It is much easier to just use strike price + spread when option is in the money to calculate effective interest. Thanks guys…it’s bed time, cause my head is about to explode.
Dude… this question was completely messed up… I couldn’t even figure out what the rate on the loan was… Schweser practice exams were way off base in my opinion… PJStyles