Careful Bank is a lender in the floating-rate instrument market

Careful Bank is a lender in the floating-rate instrument market. It uses fixed-rate financing on its floating-rate loans and buys floors to hedge the rate. It makes a $20 million one-year loan on 16 July. The loan is an interest-only loan, equiring quarterly interest payments on the 16th day of each corresponding month: 16 October, and 16

January, 16 April, and 16 July of the following year, with the full principal payment

at the end on 16 July of the following year. The interest rate is 90-day LIBOR plus

250 basis points. Current 90-day LIBOR is 6 percent, which sets the rate for the first

three-month period at 8.5 percent. The rates are reset every three months. To protect

itself against the risk of decreases in interest rates when the rates are reset, the company

purchases an interest rate floor. The component floor lets expire on the rate reset

dates. LIBOR on the following dates turn out to be as given:

16 October: 5.25 percent

16 January: 5.50 percent

16 April: 5.75 percent

A.Determine the effective interest payments if the bank had purchased a floor with

an exercise rate of 5.75 percent, with a premium of $50,000 paid up front on 16 July.

B. Determine the effective interest payments if the bank had purchased a floor with

an exercise rate of 6.00 percent, with a higher premium paid up front on 16 July.

C.Determine the effective interest payments if the bank had purchased a floor with

an exercise rate of 5.50 percent, with a lower premium paid up front on 16 July.

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