Please Solve It

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Question

XYZ Plc. borrows 20 Million Pounds of 6 months LIBOR+0.25% for a period of two years.

Mr. David, Treasury Manager of XYZ anticipates a rise in LIBOR, hence proposed to buy a Cap Option from a ABC Bank at strike rate of 7%.

The lump sum premium is 1% for the whole of the three resets period and the fixed rate of interest is 6% p.a. The actual position of LIBOR during the month coming reset period is as follows:

Reset Period LIBOR

1 8.00%

2 8.50%

3 9.00%

This is question of May 2011 RTP Final New Course.

I am not able to understand the "Calculation of Premium Payable to bank " which is computed in the solution as follows :

0.01

= ------------------------------------------- x 20,000,000

(1/0.03) - ---------------------

0.03 x (1.03)4 ( i.e. 1.03 have its power 4)

Please interpret it.

Thanks in Advance!

Replies (3)

CA SAHIL MITTAL

JOB

240 Points Posted on 06 July 2011

Dear forget this formula... Try it.

In the given question, we have been given lumpsum premium of 1%.

The objective is the convert this lumpsum amount in equalised half yearly payments.

Lumpsum Premium = 20 million * 1% = 2 Lakhs

Now fixed rate of interest = 6% annaully = 3% half yearly.

Period = 2 years = 4 half years

Annuity factor @ 3% for 4 periods = 3.717

Hence, equalised payments = 200000/3.717 = 53806..

Difference is due to rounding off by institute in the material.. check it.

Guest

Thanks...thank you so much, how silly i am

Your answer wrong, we have to discount from 2nd period to 4th period not from 1st period, First 3 month borrowing rate is decided at 0th day which is current spot interest rate. No one hedges at spot rate. Annuity factor @ 3% from 2nd to 4th is 2.7462