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May 15, 2016 at 3:39 pm
example 7 chapter 20 has no answers at the back. Could you please advise?
John Moffat says
May 15, 2016 at 3:51 pm
No there isn’t and I must add an answer.
However, I have written a full explanation of how collars work – you can find it linked from the main P4 page.
May 15, 2016 at 1:02 pm
In previous examples, when predicting the effective interest rate we added the changes in basis risk. Why do we use the premium this time?
Why did you use the 94.25 as your strike price? If we were ask to determine the most suitable strike price how would you do this? Would you assume to take the strike price closest to the LIBOR rate on the 13/08 (ie 5%) hence the strike price closest to 95.00. Or would you take 6,4% hence the strike price closest to 93,6?
May 15, 2016 at 2:07 pm
Firstly, we can’t predict an effective interest rate because these are options. All we can do is determine the worst interest rate we could suffer (because if interest rates moved the other way then we would not exercise the options).
Secondly, since the premium is payable whether or not the option is exercised it makes the overall cost greater (there is no premium payable when we are simply dealing in futures rather than using options).
Thirdly, there isn’t really any such thing as a ‘best’ exercise price. This is because although different exercise prices create different ‘worst’ outcomes, for better ‘worst’ outcomes you pay a higher premium which might end up being wasted if we do not need to exercise the option. In the exam, ideally you would calculate for all available exercise prices and then discuss (which actually does not take too long – once you have done it for one it is rather repetitive). However if you are short of time, just illustrating for one exercise price (and then discussing) would get most of the marks – the marks are mainly for proving that you know how options work.
May 15, 2016 at 3:31 pm
thank you very much
May 15, 2016 at 3:49 pm
You are welcome 🙂
March 23, 2016 at 10:59 am
Is Agne premium of 1.4% given in qn?
March 23, 2016 at 2:05 pm
I assume that you have downloaded the free lecture notes (otherwise there is no point in watching the lectures!).
In the question is says that LIBOR is currently 5% and that Agne can borrow at 6.4%. Therefore she is paying a premium of 1.4% above LIBOR and we always assume that the premium will remain constant.
October 31, 2015 at 12:25 pm
HELLO SIR JOHN
IN THIS QUESTION THERE ARE 3 STRIKE PRICES ARE GIVEN FOR PUT OPTIONS ,PRIMIUMS (NET RECIPTS)
94.25 0.19 94.06
94.50 0.21 94.29
94.75 0.48 94.27
STRIKE PRICE OF 94.50 GIVES HIGHEST NET RECIPT OF 94.29 ,WHY YOU STILL USE STRIKE PRICE OF 94.25
KINDLY EXPLAIN …I AM STUCK
October 31, 2015 at 1:24 pm
Please do not type in capital letters.
The problem is that although one strike price will give the best ‘limit’ it is also has the highest cost/premium (and the option might not be used depending on what he eventual interest rate actually is).
We don’t know what the eventual outcome actually will be, and therefore we need to look at all the choices of strikes and then discuss.
November 1, 2015 at 7:29 am
sorry about that..
so please correct me if i am wrong
if there are 3 strike prices given in the exam,we must have to demonstrate maximum cap of each strike price given ! and there relevent premiums, then we chose which ever seems best and compute our answers !
November 1, 2015 at 7:30 am
November 1, 2015 at 10:25 am
Although most of the marks are for proving that you understand how options work, ideally (subject to how much time you have available) you should look at all the strike prices and then discuss.
As I wrote before, it is rare that you can say that any one of them is definitely the best (if interest rates fall and we don’t exercise the option then the one with the lowest premium would be best, but if interest rates go up then the one with the lowest maximum would be best, but obviously we do not usually know what is going to happen in the future) – it is more a question of discussing in the exam, and again proving that you understand how they work.
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