A bank is interested in buying a floor on interest rates to protect against falling interest rates.  The floor they are looking at is an option that expires in 3 years.  It can only be exercised at the end of 3 years - that is, it is European style.  The underlying rate that it is based upon in the 10-year Treasury rate.  Its strike is 1.5%.  So for 100mm in notional, its payoff will be 100mm x max (1.5% - 10-year Treasury,0).  IE, 0.50% rates will pay off 1mm.  The cost is 40 bps.

Use both an inside and outside view to assess whether this is good value.  By good value, is the expected payoff > the cost?

To calculate a forward, use 0.32% for the 3 year rates and 1.9% for the 13 year rate. Implied vol (where market is currently trading the vol) is 0.80%.

Answer rating: 100% (QA)

To assess whether the floor option is good value we will calculate the expected payoff and compare i... View the full answer