Question

In January 2021, your bank intends to make a loan of $25m with interest paid quarterly based on LIBOR at the beginning of each quarter. Assume LIBOR = 5% on Jan 1st 2021; 4.85% on April 1st 2021; 4.6% on July 1st 2021; and 5.05% on Sept 1st 2021. As an elite MSF graduate who is working in the bank, you proposed an interest rate floor instrument to curb the interest rate risk on your bank’s future cash flows related to the loan. The strike price of the floor instrument is 5% while the floor instrument premium is $45,000.

You need to tabulate the cash flows associated with the loan based on the information above. (hint: assume the year has 360 days and each quarter has 90 days)

Answer 1

Loan of $25m with interest paid quarterly based on LIBOR.
LIBOR
5% on Jan 1st 2021
4.85% on April 1st 2021
4.6% on July 1st 2021
5.05% on Sept 1st 2021

Floor = 5%. Floor Premium = $45,000
Hence if Interest rate falls below 5%, the bank will receive interest equal to 5% by paying a premium of $45,000.

For Quarter April 21 and July 21 LIBOR is 4.85% and 4.60% respectively which is less than 5%. So Floor comes into play and hence Interest rate will move up to 5%.
So for this two quarters bank will pay a premium of $45,000 which will get adjusted with the Interest Cash Flow.

Hence the Cash Flow are tabulated below :-