The O'Brien Beverage Company is considering capping a two-year \(\$ 10\) million floating-rate loan from First National Bank with a strip of Eurodollar puts. O'Brien's floating-rate loan starts on December 20 with the rate on the loan reset each quarter. The initial quarterly rate is equal to \(3.5 \% / 4\), the other rates are set each quarter on \(3 / 20,6 / 20,9 / 20\), and 12/20 over the next seven quarters to equal one fourth of the annual LIBOR on those dates plus 100 basis points: (LIBOR \(\%+1 \%\) ) \(/ 4\). The top panel in Table 8.1 shows seven Eurodollar futures put contracts with expirations coinciding with O'Brien's floating-rate loan available and their premiums on December20.

Each futures put has an exercise price of \(\$ 993,750\) ( \(X=98.5\) CME index).

a. Explain how the O'Brien Beverage Company could attain a cap on its floating-rate loan with the put options shown in Table 8.1. What is the cost of the put strip?

b. Complete Table 8.1, showing the company's quarterly interest payments, option cash flow, hedged interest payments (interest minus option cash flow), and hedged rate as a proportion of a \(\$ 10\) million loan (do not include option cost) given the LIBOR rates shown in the table.

TABLE 8.1

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T 3/20/T1 6/20/T1 9/20/T1 X Po Cost of 10 Puts: $993,750 $993,750 $993,750 4 4.2 4-4 12/20/T1 $993,750 3/20/T2 6/20/T2 9/20/T2 $993,750 $993,750 $993,750 4.6 4.8 5 5.2 Total C = 1 2 3 4 5 6 7 8 9 Date LIBOR % Futures and Spot Put Cash Flow at Value of Put Option's Quarterly Hedged Price ST Expiration Cash Flow at Payment Interest at Debt Col 6 - Col 5 Hedged Unhed; Rate [(4) Rate (Col LIBOR =fT - f,0] 10(Max[$993,750 Date (Put CF Payment (1+LIBOR)-25 [(LIBOR 7)]/$10m 100bp at T) Date + 0.01)] ($: 12/20 1.50 3/20 1.50 $996,250 $0 $62,500 $62,500.00 0.025 0.025 6/20 2.00 $995,000 $0 $0.00 $62,500 $62,500.00 0.025 0.025 9/20 2.50 12/20 3.00 3/20 3.50 6/20 4.00 9/20 4.50 12/20