Suppose Commerce Bank sells XU Trust a two-year, $15 million FRN paying the LIBOR plus 150 basis points. The note starts on 3/20 at 9% and is then reset the next seven quarters on dates 6/20, 9/20, and 12/20. Suppose a money center bank offers Commerce Bank a cap for $200,000 with the following terms corresponding to its floating-rate liability:

 The cap consists of seven caplets coinciding with the reset dates on the note

 Exercise rate on the caplets = 7%

 Notional principal = $15 million

 Reference rate = LIBOR

 Time period on the payoffs is .25

 Payoff is paid on the payment date on the note

 Cost of the cap is $200,000 and is paid on 3/20

a. Show in a table Commerce Bank’s quarterly interest payments, caplet cash flows, hedged interest cost (interest minus caplet cash flow), and hedged rate as a proportion of the $15 million FRN loan (do not include cap cost)

for each period given the following rates: LIBOR = 7.5% on 3/20/Y1, 8%

on 6/20/Y1, 9% on 9/20/Y1, 8% on 12/20/Y1, 7% on 3/20/Y2, 6.5% on 6/20/Y2, 6% on 9/20/Y2, and 5.5% on 12/20/Y2.

b. To help defray part of the cost of the cap, suppose Commerce Bank decides to set up a collar by selling a floor to one of its customers with a floor rate of 6.5% for $150,000 with the following terms:

 The floor consists of seven floorlets coinciding with the reset dates on the note

 Exercise rate on the floorlets = 6.5%

 Notional principal = $15 million

 Reference rate = LIBOR

 Time period on the payoffs is .25

 Payoff is paid on the payment date on the note

 Cost of the floor is $150,000 and is paid on 3/20

c. Evaluate Commerce Bank’s hedged interest costs from using the collar given the interest-rate scenario defined in 8a.

d. Contrast Commerce Bank’s cap hedge with its collar hedge.

e. Define another interest rate option position Commerce Bank might use to defray the costs of its cap-hedged floating-rate liability.