Reading 28
So the denominator of the equation for the effective annual interest rate is the effective loan, basically notl with the compounded option premium.
Question- why is it that when a borrower who BUYS an interest rate call to hedge against interest rate increases, the compounded option premium is SUBTRACTED from the notional, whereas for a lender who BUYS a put to hedge against a decrease in rates would ADD the compounded option premium to the notional? In both cases, the purchase of an option in my opinion, should be negative since it’s costly and should be subtracted. Please explain.
For the borrower, during the time they purchased the option, it is a cash outflow. When the option expires, that is the time the borrower will RECEIVE the proceeds from the availed loan. So therefore, when the option expires, the value of your position is AMOUNT RECEIVED (proceeds of the loan) - EFFECTIVE VALUE OF THE CALL. (positive cash flow for the amount borrowed, negative cash flow from the amount paid for the call)
For the lender, during the time they purchased the put option, it is a cash outflow. When the option expires, that is the time the lender will GIVE THE AMOUNT to the borrower. So therefore, when the option expires, the value of your position is AMOUNT PAID and the EFFECTIVE VALUE OF THE PUT (both are negatives)