Guys,
Just going over answers to a Fin Quiz mock (never using that provider again), not trusting some of the solutions. Please verify the following formula:
Effective interest on loan = interest due on loan + caplet payoff - floorlet payoff
Shouldn’t it be subtracting both payoffs, including the floorlet payoff, as proceeds from either source offset the interest due on the loan?
Thanks all.
You need to understand which perspective you are looking at this example from. You are either a lender or a borrower.
Generally I will use either a caplet or flooret.
Floating rate lender (higher rates = more interest and profit for me): I need to protect against falling rates so I use a flooret. This hedges the minimal amount of interest I will receive from my borrower. Interest Due + Flooret Payoff. I get more interest.
Floating rate borrower (lower rates = less interest expense for me): I need to protect against rising rates so I use a caplet. This hedges the maxium amount of interest I will pay to my lender. Interest Due - Caplet. I pay less interest.
In some cases both may be used at the same time. Banks usually do this. They sell floorets and buy caplets. The bank can earn premiums selling the floors, but they are protected if rates rise with the caplets they purchased. This is done to hedge their deposit base. From that perspective I think the formula should be Effective Interest Due = interest due - caplet payoff + flooret payoff. I’m short the flooret.