CFA example 11 #1, page 438 book 5 Interest Rate Options positive, effective, interest, solution, example

bbtomato

Looking at the solution, the effective rate on the loan is 9.25%, which is greater than what it would have been (9%) if he didn’t buy the interest rate call, correct? So in this case, even though the call had a positive payoff, he would have been better of NOT hedging? Am I evaluating this correctly?

Dapper425

Call is a sunk cost against borrowing. If I didn’t have to pay for a call in case rates went up and rates didn’t go up of course it would be cheaper…
Effective Interest Rate is however always going to be higher than 360 day convention so it is skewed a bit.
365/360 for EAR.

adehbone

if he bought an option, then what he is paying for the extra interest, he is getting paid for by the value of an option (imagine he bought a cap with a strike of 9%, which is now in the money).

bchadwick

Paraguay, rates DID go up, that is my point, the option payoff was POSITIVE, and his borrowing costs were STILL HIGHER than if he didn’t hedge…. just strange.

cfalevel2011

YES because it is an EAR and it has a SUNK COST OF THE PREMIUM.
Dividing by 1 instead of (1 - option cost) and raising to 365/360 convention instead of 360 day LIBOR convention is going to make the RATE GO UP, beyond the 360 day convention of interest rates.