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. Assume that LIBOR is expected to be 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 total payments received (or paid) by Lizard can be calculated as follows:

1. In the first year, LIBOR is expected to be 9 percent, which is below the interest rate ceiling of 11 percent. Therefore, no payment is made to Lizard.

2. In the second year, LIBOR is expected to be 12 percent, which is above the interest rate ceiling of 11 percent. Therefore, Lizard receives a payment equal to the difference between the LIBOR rate and the interest rate ceiling, which is $50 million x (12% - 11%) = $500,000.

3. In the third year, LIBOR is expected to be 13 percent, which is above the interest rate ceiling of 11 percent. Therefore, Lizard receives a payment equal to the difference between the LIBOR rate and the interest rate ceiling, which is $50 million x (13% - 11%) = $1,000,000.

Adding the initial fee of $1 million, the total payments received by Lizard are $1 million + $500,000 + $1,000,000 = $2.5 million. However, the question asks for the total payments received or paid by Lizard, so we need to account for the initial fee as a payment made by Lizard. Therefore, the total payments received or paid by Lizard are $500,000.

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