2011 mock exam Q 39

[g3r41d]

@calcfa2011

Its correct, for banks making a loan, the cost of the option is added to the denominator therefore lowering the interest rate in the numerator, in exchange for a hedge they make less. For the borrower, the cost would be subtracted from the denominator making it more expensive to hedge, a higher interest rate. Interest rates are revenue to banks and cost to borrowers. If banks made more by hedging and borrowers spent less by hedging, every loan would be hedged.

Yeap. This is the key part.

If calculating interest based on borrowings, then net borrowing = principal - FV( cost of option)

If calculating interest based on loans, then net loan = principal + FV( cost of option )