Question 1

On Jan 1, a firm plans to borrow $20 million for 90 days beginning on Feb 1 (31 days in the future, which is the maturity of the call). It can currently borrow at LIBOR plus 200 basis points, and LIBOR is currently 5.5%.

The firm buys an interest rate call option where LIBOR is the underlying, and the strike rate is 5%. The notional principal is $20 million, and D = 90 days, which is also the length of the loan.

Calculate the effective payments of the borrower when LIBOR is 3.0%, 4.8%, and 6.5%.