2011 mock exam Q39 examples, interest, decrease, effective, 2011

DoubleDip

The question asks to compute the effective interest rate when loaning out LIBOR+spread and using put option to protect against decrease of interest rate.

I got the 6 month return rate right, but I annualized the rate by (1+r)^2-1. The provided answer and textbook examples used (1+r)^(365/180)-1.

Can someone explain the day count convention here? The question specifically states the day count convention for the option is 30/360.

Thanks!

Chuckrox

This is standard practice in banking.

Ear based on 365, I remember it from grad school from a book that wasn't related to cfai. Never understood why but apparently it is the standard.



Edited 1 time(s). Last edit at Sunday, May 29, 2011 at 05:19PM by Paraguay.

PalacioHill

it must be 365 days, you are now calcuating the reate earned over a period during a year, hence use 365.

In all other parts of that calculation process you use the LIBOR hence the use of 360 days but when calculating the EAR it simplifies to

what rate must be earned on $x for it to grow to $y over a period less than a year

Windjam

Thanks all.

If there is no strong reason, my last resort is to memorize it. Guess the real exam will ask us to do the borrower side :-)

Zestt

anyone have any insight?

infinitybenzo

To me, it doesn't matter. Normally, your option's expiration will be 3 months, 6 months or 9 months and I will only use month ratio as 12/3; 6/12...

mik82

I don't know why, but I am sure I already remember this for tomorrow.

NakedPuts2011

to convert the rates to LIBOR - use 360 days convention.

to convert to EAR use 365 days convention.
Puts and Calls are valued at say 90/360, 180/360 and so -- LIBOR based.

when you finally convert to EAR --> use ^(365/180) -1 or ^(365/90) -1

CP

skycfa

abmaroon, the relevant period is 6/30/11-1/1/12, not 1/1/11-6/30/11

CP, thanks I think you answered my question, another CFA idiosyncratic rule, just use 90/180/270 and nothing else