Question

An investor purchases a cap on 7/1/20 for an initial premium of 1.65% of the notional amount. The terms of the cap include the following:

1) The notional amount is $250,000,000

2)The reference rate is 3-month LIBOR

3) The maturity of the contact is 1 year

4) Cap payments are made quarterly

5) The strike price is 2.45%

6) The payment is based on actual/360 day count

LIBOR for the 10/1/20, 1/1/21, 4/1/21, and 7/1/21 LIBOR reset dates is 1.7575%, 2.2825%, 2.7175%, and 3.1250%, respectively.

a) What is the amount of the initial premium payment? Which party pays? What is the amount of each cap payment? Which party pays?

Answer 1

Answer (a):

Amount of initial premium = 1.65% of notional amount i.e. 250,000,000 = $ 4,125,000/-

in the given question investor is purchasing a cap hence he has to pay the premium to the cap provider.

Answer (b) :

On the 10/1/20 interest rate is at 1.7575% which is less than the strike rate of 2.450% hence cap provider does not need to pay anything to the investors, hence it will be zero 0.

On the 1/1/21 interest rate is at 2.2825% which is less than the strike rate of 2.450% hence cap provider does not need to pay anything to the investors, hence it will be zero 0.

On the 4/1/21 interest rate is at 2.7175% which is higher than the strike rate of 2.450% hence cap provider will pay the difference of the interest rate to the investor:

= (Current rate - Strike price rate) x notional amount x Period/12

= (2.7175% - 2.450%) x $250,000,000 x 3/12 = $ 167,187.5

On the 7/1/21 interest rate is at 3.1250% which is higher than the strike rate of 2.500% hence cap provider will pay the difference of the interest rate to the investor:

= (Current rate - Strike price rate) x notional amount x Period/12

= (3.1250% - 2.450%) x $250,000,000 x 3/12 = $ 421,875

Cap provider will pay the amount of cap payment to investors. it will be as follows:

10/1/20 0

1/1/21 0

4/1/21$ 167,188

7/1/21 $ 421,875