Question

As a manager of a commercial bank, you just purchased a three-year interest rate collar with LIBOR as the interest rate index. The interest rate cap specifies a fee of 2 percent of notional principal (valued at $100 million) and an interest rate ceiling of 9 percent. The interest rate floor specifies a fee of 3 percent of the $100 million notional principal and an interest rate floor of 7 percent. Assume that LIBOR is expected to be 6 percent, 10 percent, and 11 percent (respectively) at the end of each of the next three years.
a. Determine the net fees paid, and also determine the expected net payments to be received as a result of purchasing the interest rate collar.
b. Assuming you are very confident that interest rates will rise, should you consider purchasing a callable swap instead of the collar? Explain.
c. Explain the conditions under which your purchase of an interest rate collar could backfire.

Answer 1

I have answered the question below

Please up vote for the same and thanks!!!

Do reach out in the comments for any queries

Answer:

Interest rate cap
LIBOR		6%	10%	11%
Interest rate ceiling		9%	9%	9%
LIBOR above ceiling rate (1)		0%	1%	2%
Fees on cap ($100 million × 2%) (2)	$2,000,000
Interest rate floor
LIBOR		6%	10%	11%
Interest rate floor		7%	7%	7%
LIBOR below floor rate (3)		1%	0%	0%
Fees on floor ($100 million × 3%) (4)	$3,000,000
Net fees received (4-2)	$1,000,000
Net payment received (1-3) × $100 million		-$1,000,000	+$1,000,000	+$2,000,000