DAY LIBOR PLUS 300 BPS. PRINCIPAL AND INTEREST WILL BE PAID AT THE...

180-day Libor plus 300 bps. Principal and interest will be paid at the end of the loan term. The

client is concerned about a potential increase in interest rates before the initiation of the loan, and

asks for advice on fully hedging this interest rate risk.

A derivatives analyst at Devon advises the client to buy an interest rate call option on 180-day

Libor with an exercise rate of 2.0% for a premium of USD 86,000. The call expires in 109 days

and any payoff occurs at the end of the loan term. Current 180-day Libor is 2.2%. The client

can finance the call option premium at current 180-day Libor plus 300 bps.

At initiation of the loan 109 days later, 180-day Libor is 3.5%.

C. Calculate the effective annual rate (in bps) on the loan. Show your calculations.

8 minutes (Answer 8-C on page 51)

Page 48 Level III

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