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Hedging an anticipated loan with an interest rate call option

A company plans to borrow $20 million in 30 days at 90-day LIBOR plus 1%. The loan involves a single repayment of interest and principal 90 days later. The company buys an interest rate call option for $14,866 to manage interest rate risk. The exercise rate is 5%. The current 30-day LIBOR rate is 4%, and the company will have to pay this rate plus 1% if the loan were taken out today.

Determine the effective annual rate on the loan with and without the call option for each of the following outcomes: 90-day LIBOR at expiration is 3%, 4%, 5%, 6%, and 7%.

Note: Interest is computed by dividing the number of days by 360, but use 365 when computing the effective rate.

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Financial Management, Finance

Category:- Financial Management
Reference No.:- M92429028

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