Question

Lizard National Bank purchases a three-year interest rate cap for a fee of 2 percent of notional principal valued at $50 million, with an interest rate ceiling of 11 percent and LIBOR as the index representing the market interest rate. Lizard selles-a three year (8 percent) for a fee of 1 percent of the 50$ notion Principal. A libor is expected to be 7 percent, 12 percent, and 13 percent at the end of each of the next three years. 1. what is the name of this strategy? 2. How much Lizard received (or paid) using this strategy ?

Answer 1

Lizard purchases an interest rate cap (11%) and sells an interest rate floor (8%). Lizard will receive a payment from the cap if rates rise above 11%, and Lizard will make a payment on the floor if rates fall below 8%.  

This strategy is called an interest rate collar

fee paid on cap = $50 million * 2% = $1 million

fee received on floor = $50 million * 1% = $0.5 million

At end of year 1 :

payment received from cap = 0

payment made on floor = (8% -7%) * $50 million = $0.5 million

At end of year 2 :

payment received from cap = (12% - 11%) * $50 million = $0.5 million

payment made on floor = 0

At end of year 3 :

payment received from cap = (13% - 11%) * $50 million = $1 million

payment made on floor = 0

Net amount received = $0.5 million - $1 million - $0.5 million + $0.5 million + $1 million = $0.5 million