Schweser Vol 1 Exam 3 Page 180-181 Q18

On question 18.2, how do you determine the terminal value of the call option premium (i.e 0.000943443 x $25m). There is no current LIBOR given to find its terminal value in 90 days (bec premium is paid upfront). My working is as follows: Payoff from call option (in the money) = (5.73 - 4.8)% x $25m x 180/360 =$116,250 Interest cost = (5.73+1.5)% x $25m x 180/360 = -$903,750 Premium (as above) = $23,586 and (terminal value if i use 5.73% as discount rate (best estimate = 23586 x (1.0573)^90/365 = 23912) Annual effective rate = [(25m - 116,250 + 903,750)/ (25m - 23,912)]^(365/180) = 6.6978% Correct answer is : A 6.6982%

As far as i can see you’ve calculated the future value of the premium incorrectly. You’ve used 5.73% as the compunding rate but it should be 4.8 + 1.5 = 6.3% (i.e. the cost if the premium was paid for with a loan at CURRENT rates.)

Should have added, we have to assume that 4.8% is the current rate as it’s also the option strike rate - not sure if this is a common assumption we’re expected to make or not…

thanks man, guess it has to be the strike rate as the current LIBOR since the strike being the hedged rate should be the current LIBOR.

See the errata. There should have been a current libor rate provided. Schweser practice questions are really terribly written…

thanks pal