General Electric

Needs
Lufthansa is looking for a supplier of turbine blades for its
aircrafts worth 10 million.
GE submitted a bid to supply the turbine blades in
January 1. GE has to wait for another 3 months before
knowing whether they won the bid or not because the
announcement for the winning bid will be made only 3
months later on April 1.
If GE wins, Lufthansa will have to pay GE on December
31.
The current January 1 spot rate is US$ 1.00 / . The one
year forward rate is US$ 0.957 / .
General Electric

The Problem

GE would like to guarantee that the exchange rate does

not move against it between the time it bids on January 1
and the time it gets paid on December 31 should it win
the contract.

What should GE do?

General Electric
The Solution
Alternative 1 Currency Forward
GE will sell the anticipated 10 million receivable forward
on January 1.
Scenario 1 GE loses the bid
On April 1, GE was informed that it had lost the bid to
supply Lufthansa the turbine blades. The forward rate on
April 1 for December 31 delivery went up to US$ 1.002 /
from US$ 0.957 / on January 1.
GE would lose:
10 million x (US$ 0.957/ - US$ 1.002) = (US$ 450,000)
General Electric
The Solution
Alternative 1 Currency Forward
Scenario 2 GE wins the bid
On April 1, GE was informed that it had won the bid to
supply Lufthansa the turbine blades.
The euro declines in value. The April 1 forward rate for
December 31 delivery falls to US$ 0.90 / from US$ 0.957 /
on January 1.
GE would receive a smaller amount on December 31 and
thus lose money.
10 million x (US$ 0.900/ - US$ 0.957) = (US$ 570,000)
General Electric

The Solution

Alternative 2 Currency Option

On January 1, GE buys a put option from a bank dealer

with a premium costing US$ 100,000 to the right to sell
10 million on December 31 to the bank dealer at a forward
rate (price) of US$ 0.957 / . This means GE will receive a
minimum of US$ 9.57 million if it wins the bid.
General Electric

The Solution

Alternative 2 Currency Option

Scenario 1 GE loses the bid

On April 1, GE was informed it lost the bid.

GE will not exercise the put option. It will just let it

expire worthless. Cost to GE will be the premium cost
of US$ 100,000.
General Electric
The Solution
Alternative 2 Currency Option
Scenario 1 GE wins the bid
On April 1, GE was informed it won the bid.
If the spot price on December 31 is higher than the option
rate of US$ 0.957 / . GE will exercise the put option on
December 31 and will sell 10 million at US$ 0.957 / .

If the spot rate on December 31 is lower than US$ 0.957/

, then GE will not exercise the put option but instead
convert the 10 million at the prevailing spot rate.
Colgate Palmolive Company

Needs

In April, Colgate Palmolive Company decided it needs a

short term loan four months later and wants to borrow a
floating rate loan. It approached its bank for the future
dated loan. The bank approved the loan.

The loan amount is $ 40 million. The loan rate will be set

at LIBOR plus 200 basis points on August 20.
Colgate Palmolive Company

Needs

Current LIBOR is 5.5%. The loan will be repaid in a single

bullet payment (principal plus interest) 180 days later on
February 16.

Colgate Palmolive is worried interest rates might go up

during the 4 months waiting period from April to August.

It wants to pay the loan at the current level of LIBOR.

Colgate Palmolive Company

The Problem

a. What should Colgate Palmolive do to lock in the loan

rate in August at the current levels of LIBOR in April?

b. What will be the payoff to offset any increase in interest

rates (LIBOR)?

c. What will be the effective loan rate if the effects of the

payoff are included?
Colgate Palmolive Company

The Solution

To protect itself against an increases in LIBOR between

April 14 and August 20 (128 days) before the loan is
actually drawn and used, Colgate Palmolive will buy a call
option on LIBOR with an exercise rate of 5% to expire
August 20 with a 180 day LIBOR as underlying.

The call premium is $ 100,000. LIBOR on August 20 is

8%.
Colgate Palmolive Company

The Solution

Call Payoff = $ 40,000,000 x max [0, LIBOR-0.05](180/360)

on Aug 20 = $ 40,000,000 x max [0, 0.08-0.05](180/360)
= $ 360,000
Premium FV = $ 100,000 [ 1+(0.055+0.02)(128/360)]
(Apr 14 t0 = $ 102,667
Aug 20)
Colgate Palmolive Company
The Solution
Net Loan Proceeds = Loan amount FV call premium
= $ 40,000,000 - $ 102,667
= $ 39,897,333
Loan interest (Feb 16) = $ 40,000,000 (LIBOR on Aug 20 + 200 bp)(180/380)
= $ 40,000,000(0.08+0.02)(180/360)
= $ 2,000,000
Effective Loan Rate = (Loan Principal + Interest - Call Payoff)365/180 - 1
Net Loan Proceeds
= ($40,000,000 + $2,000,000 - $600,000)365/180 - 1
$39,897,333
= 0.0779 or 7.79%
 Colgate Palmolive Company
The Solution
Loan Interest Effective
LIBOR on Loan Paid on Call Effective Loan
Aug 20 Rate Feb 16 Payoff Interest Rate
0.010 0.030 $600,000 $0 $600,000 0.0360
0.015 0.035 $700,000 $0 $700,000 0.0412
0.020 0.040 $800,000 $0 $800,000 0.0464
0.025 0.045 $900,000 $0 $900,000 0.0516
0.030 0.050 $1,000,000 $0 $1,000,000 0.0568
0.035 0.055 $1,100,000 $0 $1,100,000 0.0621
0.040 0.060 $1,200,000 $0 $1,200,000 0.0673
0.045 0.065 $1,300,000 $0 $1,300,000 0.0726
0.050 0.070 $1,400,000 $0 $1,400,000 0.0779
0.055 0.075 $1,500,000 $100,000 $1,400,000 0.0779
0.060 0.080 $1,600,000 $200,000 $1,400,000 0.0779
0.065 0.085 $1,700,000 $300,000 $1,400,000 0.0779
0.070 0.090 $1,800,000 $400,000 $1,400,000 0.0779
0.075 0.095 $1,900,000 $500,000 $1,400,000 0.0779
0.080 0.100 $2,000,000 $600,000 $1,400,000 0.0779
0.085 0.105 $2,100,000 $600,000 $1,400,000 0.0779
0.090 0.110 $2,200,000 $600,000 $1,400,000 0.0779
Kookmin Bank

Needs

Kookmin Bank committed on March 15 to lend a short term

loan of $ 50 million to Samsung Electronics at 90 day
LIBOR plus 250 bp on May 1 or around 1 months later.

The loan will be repaid with a single bullet payment

(principal plus interest) three months later on July 30.

Kookmin Bank is worried that interest rates (LIBOR) might

decline during the interim period of 1 months before the
loan is actually drawn down and used.
Kookmin Bank

The Problem

a. What should Kookmin do to lock in the loan rate

(LIBOR) in March?

b. What will be the payoff to offset any decrease in

interest rates (LIBOR)?

c. What will be the effective loan rate if the effects of the

payoff are included?
Kookmin Bank

The Solution

To protect itself against a decrease in LIBOR between

March 15 and May 1 (47 days or around 1 months)
before the loan is actually drawn and used, Kookmin Bank
will buy a put option with an exercise price of 7% expiring
on May 1.

Put premium is $ 62,500. LIBOR on May 1 is 6%. Current

LIBOR is 7.25%. The underlying is a 90 day LIBOR.
Kookmin Bank

The Solution

Put Payoff = $ 50,000,000 x max [0, 0.07-LIBOR](90/360)

on May 1 = $ 50,000,000 x max[0, 0.07-0.06](90/360)
= $ 125,000
Premium FV = $ 62,500 [ 1+(0.0725+0.025)(47/360)]
(Mar 15 = $ 63,296
to May 1)
Kookmin Bank

The Solution
Net Amount Loaned = Loan amount + FV put premium
= $ 50,000,000 + $ 63,296
= $ 50,063,296
Loan interest (Jul 30) = $ 50,000,000 (LIBOR on May 1 + 200 bp)(180/380)
= $ 50,000,000(0.06+0.025)(90/360)
= $ 1,062,500
Effective Loan Rate = (Loan Principal + Interest + Put Payoff)365/90 - 1
Net Amount Loaned
= ($50,000,000 + $1,062,500 + $125,000)365/90 - 1
$50,063,296
= 0.0942 or 9.42%
 Kookmin Bank
The Solution
LIBOR on Loan Paid on Put Effective Loan
May 1 Rate Jul 30 Payoff Interest Rate
0.010 0.055 $687,500 $500,000 $1,187,500 0.0942
0.015 0.060 $750,000 $437,500 $1,187,500 0.0942
0.020 0.065 $812,500 $375,000 $1,187,500 0.0942
0.025 0.070 $875,000 $312,500 $1,187,500 0.0942
0.030 0.075 $937,500 $250,000 $1,187,500 0.0942
0.035 0.080 $1,000,000 $187,500 $1,187,500 0.0942
0.040 0.085 $1,062,500 $125,000 $1,187,500 0.0942
0.045 0.090 $1,125,000 $62,500 $1,187,500 0.0942
0.050 0.095 $1,187,500 $0 $1,187,500 0.0942
0.055 0.100 $1,250,000 $0 $1,250,000 0.0997
0.060 0.105 $1,312,500 $0 $1,312,500 0.1051
0.065 0.110 $1,375,000 $0 $1,375,000 0.1106
0.070 0.115 $1,437,500 $0 $1,437,500 0.1161
0.075 0.120 $1,500,000 $0 $1,500,000 0.1216
0.080 0.125 $1,562,500 $0 $1,562,500 0.1271
0.085 0.130 $1,625,000 $0 $1,625,000 0.1327
0.090 0.135 $1,687,500 $0 $1,687,500 0.1382
Samsung Semiconductor

Needs

Samsung Semiconductor borrowed a $ 10 million three year

loan at 100 bp over LIBOR. It will pay interest semi-
annually and the full principal at the end of three years.

Current LIBOR is 9%. Interest will be based on the exact

number of days in the six month period.

Samsung Semiconductor is worried about interest rates

(LIBOR) rising during the 3 year life of the loan which will
push up its loan cost.
Samsung Semiconductor

The Problem

a. What should Samsung Semiconductor do to lock in the

loan rate (LIBOR) today for the next 3 years during the
life of the loan?

b. What will be the payoffs of the caplets?

c. What will be the effective loan interest amounts per

reset date?
Samsung Semiconductor

The Solution

To protect itself against rising interest rate over the 3 year

life of the loan, Samsung Semiconductor will buy an interest
cap from a derivatives dealer Hana Bank with an exercise
rate of 8%.

The component caplets expire on the dates on which the

loan rate is reset.

The caplets will expire on October 15, April 15 of the

following year, and so on for three years.
Samsung Semiconductor

The Solution

But the caplet payoffs will occur on the next payment date
corresponding with the interest payment based on LIBOR
that determines the caplet payoff.

The cap premium is $ 75,000.

Samsung Semiconductor

The Solution

Loan Interest Due to Bank Per Reset Period

= $ 10,000,000 x [LIBOR on previous reset date + 100 bp](Days in Settlement

Period/360)
Samsung Semiconductor
The Solution
Caplet Payoff Per Reset Period
= $ 10,000,000 x max[0, LIBOR on current reset date 0.08](Days in Settlement
Period/360)
Oct 15 (First reset date) LIBOR is 8.50%
Loan Interest Due
= $ 10,000,000 x max[0, 0.09 + 0.01](183/360)
= $ 10,000,000 x 0.10 x (183/360)
= $ 508,333
Caplet Payoff Due on next Apr 15
= $ 10,000,000 x max[0, 0.085 0.08](182/360)
= $ 10,000,000 x (0.005)(182/360)
= $ 25,278
Samsung Semiconductor

The Solution

Apr 15 (2nd reset date) LIBOR is 7.25%

Loan Interest Due

= $ 10,000,000 x max[0, 0.085 + 0.01](182/360)
= $ 10,000,000 x 0.095 x (182/360)
= $ 480,278

Caplet Payoff Due on next Oct 15

= $ 10,000,000 x max[0, 0.0725 0.08](183/360)
= $ 10,000,000 x (0)(183/360)
=$0
Samsung Semiconductor

The Solution

Oct 15 (3rd reset date) LIBOR is 7.00%

Loan Interest Due

= $ 10,000,000 x max[0, 0.0725 + 0.01](183/360)
= $ 10,000,000 x 0.0825 x (183/360)
= $ 419,375

Caplet Payoff Due on next Apr 15

= $ 10,000,000 x max[0, 0.07 0.08](182/360)
= $ 10,000,000 x (0)(182/360)
=$0
Samsung Semiconductor

The Solution

Apr 15 (4th reset date) LIBOR is 6.90%

Loan Interest Due

= $ 10,000,000 x max[0, 0.07 + 0.01](182/360)
= $ 10,000,000 x 0.08 x (182/360)
= $ 404,444

Caplet Payoff Due on next Oct 15

= $ 10,000,000 x max[0, 0.069 0.08](183/360)
= $ 10,000,000 x (0)(183/360)
=$0
Samsung Semiconductor

The Solution

Oct 15 (5th reset date) LIBOR is 8.75%

Loan Interest Due

= $ 10,000,000 x max[0, 0.069 + 0.01](183/360)
= $ 10,000,000 x 0.079 x (183/360)
= $ 401,583

Caplet Payoff Due on next Apr 15

= $ 10,000,000 x max[0, 0.0875 0.08](182/360)
= $ 10,000,000 x (0.0075)(182/360)
= $ 37,917
Samsung Semiconductor

The Solution

Apr 15

Loan Interest Due

= $ 10,000,000 x max[0, 0.0875 + 0.01](182/360)
= $ 10,000,000 x 0.0975 x (182/360)
= $ 492,917
 Samsung Semiconductor
The Solution

Loan Days in Interest Caplet Effective

Date LIBOR Rate Period Due Payoffs Interest
Apr 15 0.0900 0.1000
Oct 15 0.0850 0.0950 183 $508,333 $508,333
Apr15 0.0725 0.0825 182 $480,278 $25,278 $455,000
Oct 15 0.0700 0.0800 183 $419,375 $0 $419,375
Apr 15 0.0690 0.0790 182 $404,444 $0 $404,444
Oct 15 0.0875 0.0975 183 $401,583 $0 $401,583
Apr 15 182 $492,917 $37,917 $455,000
Hana Bank

Needs

Hana Bank makes a $ 10 million three year loan at 100 bp

over LIBOR to Nestl Korea.

The loan payments will be made semi-annually. Current

LIBOR is 9%. Interest will be based on the exact number of
days in the six month period of the exact number of days in
the six month period.

Hana Bank is worried about falling interest rates that will

affect its interest revenue from the loan.
Hana Bank

The Problem

a. What should Hana Bank do to lock in the loan rate

(LIBOR) today for the next 3 years during the life of the
loan?

b. What will be the payoffs of the floorlets?

c. What will be the effective loan interest amounts per

reset date?
Hana Bank

The Solution

To protect itself against falling interest rate over the life of

the loan, Hana Bank should buy an interest floor from a
derivatives dealer Kookmin Bank with an exercise rate of
8%.

The component floorlets expire on the dates on which the

loan rate is reset.
Hana Bank

The Solution

The floorlets will expire on October 15, April 15 of the

following year, and so on for three years.

But the floorlet payoffs will occur on the next payment date
corresponding with the interest payment based on LIBOR
that determines the floorlet payoff.

The floor premium is $ 72,500.

Hana Bank

The Solution

Loan Interest Due From Borrower Per Reset Period

= $ 10,000,000 x [LIBOR on previous reset date + 100 bp](Days in Settlement

Period/360)
Hana Bank
The Solution
Floorlet Payoff Per Reset Period
= $ 10,000,000 x max[0, 0.08 - LIBOR on current reset date](Days in Settlement
Period/360)

Oct 15 (First reset date) LIBOR is 8.50%

Loan Interest Due From Borrower

= $ 10,000,000 x max[0, 0.09 + 0.01](183/360)
= $ 10,000,000 x 0.10 x (183/360)
= $ 508,333

Floorlet Payoff Due on next Apr 15

= $ 10,000,000 x max[0, 0.080 0.085](182/360)
= $ 10,000,000 x (0)(182/360)
=$0
Hana Bank

The Solution

Apr 15 (2nd reset date) LIBOR is 7.25%

Loan Interest Due

= $ 10,000,000 x max[0, 0.085 + 0.01](182/360)
= $ 10,000,000 x 0.095 x (182/360)
= $ 480,278

Floorlet Payoff Due on next Oct 15

= $ 10,000,000 x max[0, 0.080 0.0725](183/360)
= $ 10,000,000 x (0.0075)(183/360)
= $ 38,125
Hana Bank

The Solution

Oct 15 (3rd reset date) LIBOR is 7.00%

Loan Interest Due

= $ 10,000,000 x max[0, 0.0725 + 0.01](183/360)
= $ 10,000,000 x 0.0825 x (183/360)
= $ 419,375

Floorlet Payoff Due on next Apr 15

= $ 10,000,000 x max[0, 0.08 0.07](182/360)
= $ 10,000,000 x (0.01)(182/360)
= $ 50,556
Hana Bank

The Solution

Apr 15 (4th reset date) LIBOR is 6.90%

Loan Interest Due

= $ 10,000,000 x max[0, 0.07 + 0.01](182/360)
= $ 10,000,000 x 0.08 x (182/360)
= $ 404,444

Floorlet Payoff Due on next Oct 15

= $ 10,000,000 x max[0, 0.080 0.069](183/360)
= $ 10,000,000 x (0.011)(183/360)
= $ 55,917
Hana Bank

The Solution

Oct 15 (5th reset date) LIBOR is 8.75%

Loan Interest Due

= $ 10,000,000 x max[0, 0.069 + 0.01](183/360)
= $ 10,000,000 x 0.079 x (183/360)
= $ 401,583

Floorlet Payoff Due on next Apr 15

= $ 10,000,000 x max[0, 0.080 0.0875](182/360)
= $ 10,000,000 x (0)(182/360)
=$0
Hana Bank

The Solution

Apr 15

Loan Interest Due

= $ 10,000,000 x max[0, 0.0875 + 0.01](182/360)
= $ 10,000,000 x 0.0975 x (182/360)
= $ 492,917
 Hana Bank

The Solution

Loan Days in Interest Floorlet Effective

Date LIBOR Rate Period Due Payoffs Interest
Apr 15 0.0900 0.1000
Oct 15 0.0850 0.0950 183 $508,333 $508,333
Apr15 0.0725 0.0825 182 $480,278 $0 $480,278
Oct 15 0.0700 0.0800 183 $419,375 $38,125 $457,500
Apr 15 0.0690 0.0790 182 $404,444 $50,556 $455,000
Oct 15 0.0875 0.0975 183 $401,583 $55,917 $457,500
Apr 15 182 $492,917 $0 $492,917
Samsung Semiconductor

Needs

Samsung Semiconductor borrowed a $ 10 million three year

loan at 100 bp over LIBOR. It will pay interest semi-
annually and the full principal at the end of three years.

Current LIBOR is 9%. Interest will be based on the exact

number of days in the six month period.

Samsung Semiconductor is worried that interest rates might

go up during the life of the 3 year loan. But it also wants to
save money buying protection.
Samsung Semiconductor

The Problem

a. What should Samsung Semiconductor do to lock in the

loan rate (LIBOR) today for the next 3 years during the
life of the loan but does not want to pay for the cost of
protection?

b. What will be the payoffs of the caplets and floorlets?

c. What will be the effective loan interest amounts per

reset date?
Samsung Semiconductor

The Solution

To protect itself against rising interest rate over the life of the
loan, Samsung Semiconductor bought an interest cap from
a derivatives dealer Hana Bank with an exercise rate of
8.625%.

The component caplets expire on the dates on which the

loan rate is reset. The caplets will expire on October 15,
April 15 of the following year, and so on for three years, but
the caplet payoffs will occur on the next payment date
corresponding with the interest payment based on LIBOR
that determines the caplet payoff.
Samsung Semiconductor

The Solution

To pay for the cost of the interest cap, Samsung

Semiconductor should sell a floor at an exercise rate lower
than the cap exercise rate.

The exercise price of the floor is 7.5%. This means there

are no net premium.
Samsung Semiconductor
The Solution
Oct 15 (First reset date) LIBOR is 8.50%

Loan Interest Due

= $ 10,000,000 x max[0, 0.09 + 0.01](183/360)
= $ 10,000,000 x 0.10 x (183/360)
= $ 508,333

Caplet Payoff Due on next Apr 15

= $ 10,000,000 x max[0, 0.085 0.08625](182/360)
= $ 10,000,000 x (0)(182/360)
=$0

Floorlet Payoff Due on next Apr 15

= $ 10,000,000 x max[0, 0.075 0.085](182/360)
= $ 10,000,000 x (0)(182/360)
=$0
Samsung Semiconductor
The Solution
Apr 15 (2nd reset date) LIBOR is 7.25%

Loan Interest Due

= $ 10,000,000 x max[0, 0.085 + 0.01](182/360)
= $ 10,000,000 x 0.095 x (182/360)
= $ 480,278

Caplet Payoff Due on next Oct 15

= $ 10,000,000 x max[0, 0.0725 0.08625](183/360)
= $ 10,000,000 x (0)(183/360)
=$0

Floorlet Payoff Due on next Oct 15

= $ 10,000,000 x max[0, 0.075 0.0725](183/360)
= $ 10,000,000 x (0.0025)(183/360)
= $ 12,708
Samsung Semiconductor
The Solution
Oct 15 (3rd reset date) LIBOR is 7.00%

Loan Interest Due

= $ 10,000,000 x max[0, 0.0725 + 0.01](183/360)
= $ 10,000,000 x 0.0825 x (183/360)
= $ 419,375

Caplet Payoff Due on next Apr 15

= $ 10,000,000 x max[0, 0.07 0.08625](182/360)
= $ 10,000,000 x (0)(182/360)
=$0

Floorlet Payoff Due on next Apr 15

= $ 10,000,000 x max[0, 0.075 0.07](182/360)
= $ 10,000,000 x (0.005)(182/360)
= $ 25,278
Samsung Semiconductor
The Solution
Apr 15 (4th reset date) LIBOR is 6.90%

Loan Interest Due

= $ 10,000,000 x max[0, 0.07 + 0.01](182/360)
= $ 10,000,000 x 0.08 x (182/360)
= $ 404,444

Caplet Payoff Due on next Oct 15

= $ 10,000,000 x max[0, 0.069 0.08625](183/360)
= $ 10,000,000 x (0)(183/360)
=$0

Floorlet Payoff Due on next Oct 15

= $ 10,000,000 x max[0, 0.075 0.069](183/360)
= $ 10,000,000 x (0.0006)(183/360)
= $ 30,500
Samsung Semiconductor
The Solution
Oct 15 (5th reset date) LIBOR is 8.75%

Loan Interest Due

= $ 10,000,000 x max[0, 0.069 + 0.01](183/360)
= $ 10,000,000 x 0.079 x (183/360)
= $ 401,583

Caplet Payoff Due on next Apr 15

= $ 10,000,000 x max[0, 0.0875 0.08625](182/360)
= $ 10,000,000 x (0.00125)(182/360)
= $ 6,319

Floorlet Payoff Due on next Apr 15

= $ 10,000,000 x max[0, 0.075 0.0875](182/360)
= $ 10,000,000 x (0)(182/360)
=$0
Samsung Semiconductor

The Solution

Apr 15

Loan Interest Due

= $ 10,000,000 x max[0, 0.0875 + 0.01](182/360)
= $ 10,000,000 x 0.0975 x (182/360)
= $ 492,917
 Samsung Semiconductor

The Solution

Loan Days in Interest Caplet Floorlet Effective

Date LIBOR Rate Period Due Payoffs Payoffs Interest
Apr 15 0.0900 0.1000
Oct 15 0.0850 0.0950 183 $508,333 $508,333
Apr15 0.0725 0.0825 182 $480,278 $0 $0 $480,278
Oct 15 0.0700 0.0800 183 $419,375 $0 -$12,708 $432,083
Apr 15 0.0690 0.0790 182 $404,444 $0 -$25,278 $429,722
Oct 15 0.0875 0.0975 183 $401,583 $0 -$30,500 $432,083
Apr 15 182 $492,917 $6,319 $0 $486,598