Question

An investor purchases a cap on 12/31/16 for an initial premium of 0.75% of the notional amount. The terms of the cap include the following:

(i) the notional amount is $10 million;

(2) the reference rate is 3-month LIBOR;

(3) the maturity of the contract is 1 year;

(4) cap payments are made quarterly;

(5) the strike price is 2.500%; and

(6) the payment is based on an actual/360 day count. LIBOR for the 3/31/17, 6/30/17, 9/30/17 and 12/31/17 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?

(b) What is the amount of each cap payment? Which party pays?

Answer 1

Answer (a):

Amount of initial premium = 0.75% of notional amount i.e. 10 million. = $ 75,000/-

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

Answer (b) :

On the 3/31/17 interest rate is at 1.7575% which is less than the strike rate of 2.500% hence cap provider does not need to pay anything to the investors, hence it will be zero 0.

On the 6/30/17 interest rate is at 2.2825% which is less than the strike rate of 2.500% hence cap provider does not need to pay anything to the investors, hence it will be zero 0.

On the 9/30/17 interest rate is at 2.7175% 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

= (2.7175% - 2.500%) x 1000000 x 3/12 = $ 543.75

On the 12/31/17 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% - 2.500%) x 1000000 x 3/12 = $ 1562.50

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

3/31/2017 0

6/30/2017 0

9/30/2017 $ 543.75

12/31/2017 $ 1562.50.