R29 EOC Q9

[whatsyourgovt]

A company plans to borrow 20m in two years. The loan will be fore three years and youll pay floating interest rate of libor on a qtrly basis. The company expects rates to increase in 2 years and thus enters into a paytor swaption (fs,2,5) with an exercise rate of 5% costing 250k. Assume libor at the beg of the settlement period is 6.5%
a. calculate the net cash flow on the first settlement if fs(2,5) is > exercise rate
b. cal the net cf on the first settlement if fs(2,5) is < exercise rate
So, i get in a you’ll exercise it and end up paying (in sum) 5%. Easy. In B it states you’ll let it expire (which also makes sense). But then the book says you can go in the market and buy a payor swap w an exercise rate of, as an example, 4% and receive 6.5% (libor). This doesnt make sense to me, why would libor still be at 6.5% if the exercise rate is 4%.

 

[Galli]

Absent of other details im failing to see how Libor couldn’t be 6.5%? Did the question say the libor rate changed by the first settlement date?

 

[magicskyfairy]

Is that really what the book said? or did it say something else, and what you’ve written here was your interpretation of what it actually said? perhaps you should consider posting the actual question, and the actual solution… not all of us have our books handy

 

[arigolden]

Wouldnt the answer here require us to just calculate the payoff of the swaption and net it against what we pay on the floating rate note?
Part A) on the settlement day of 2 years you would exercise the swaption because S > X?
Swaption Payoff = (6.5% - 5%) * 20,000,000 = +300,000
Loan payment = 20mm * (6.5%/4) = -325,000
Net Cashflow = -25,000
Part B) on the settlement day of 2 years the swaption expires out of the money as S < X.
Swaption payoff = 0
Loan Payment = 20mm * whatever the lower floating rate is now (don’t see an actual lower libor rate posted in the question).