Takeda Development Corporation has issued a $100 million floating rate note (FRN) that will mature in three years. The FRN has quarterly coupons equal to three-month LIBOR, payable in arrears and due on the first business day of each quarter. Anne Yelland, Takeda Development’s treasurer, wants to hedge against an increase in three-month LIBOR during the remaining term to maturity of the FRN. To implement the hedge, she realizes she can use either of two alternatives: an interest rate cap or a package of over-the-counter (OTC) call options on interest rates.
a. State whether, to correctly implement the hedge using each of the two alternatives, Yelland should (1) buy or sell an interest rate cap, or (2) buy or sell a package of over-the-counter (OTC) call options on interest rates. Discuss one requirement that both alternatives must meet for Yelland’s hedge to be effective.
Yelland decides to implement the hedge using an interest rate cap with the following characteristics:
• The reference rate on the interest rate cap is three-month LIBOR.
• The cap rate (strike rate) is 5.50 percent.
• The length of the agreement is for the remaining three-year life of the FRN.
• The notional principal of the cap is $100 million.
• There is quarterly settlement of the cap, payable in arrears.
The following table shows the three-month annualized LIBOR observed on the first business day of each quarter during the first year of the cap:
THREE-MONTH ANNUALIZED LIBOR BEGINNING OF EACH QUARTER
Quarter Three-month Annualized LIBOR
1 ................ 4.50%
2 ................ 6.50%
3 ................ 7.50%
4 ................ 7.00%
b. Compute the payoff (in dollars) to the interest rate cap at the beginning of each of the following two quarters: (1) Quarter 2, and (2) Quarter 3.