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. LIBOR is 9 percent, 12 percent, and 13 percent at the end of each of the next three years, respectively. The total payments received (or paid)by Lizard, including the initial fee, are $____.

Question

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The initial fee is $50 million x 2% = $1 million. The cap is triggered in years 2 and 3, when LIBOR is 12% and 13%, respectively. The payments received by Lizard are $50 million x (12% - 11%) = $500,000 in year 2 and $50 million x (13% - 11%) = $1 million in year 3. The total payments received are $1 million + $500,000 + $1 million = $2.5 million.

Lizard National Bank Purchases a Three-Year Interest Rate Cap for a Fee