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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