Option premium – how to do it correctly?

Home Forums Ask ACCA Tutor Forums Ask the Tutor ACCA P4 Exams Option premium – how to do it correctly?

This topic contains 2 replies, has 3 voices, and was last updated by Profile photo of John Moffat John Moffat 1 year, 11 months ago. This post has been viewed 300 times

Viewing 3 posts - 1 through 3 (of 3 total)
  • Author
    Posts

  • avatar
    lala169
    Participant
    • Topics: 1
    • Replies: 2

    Hello! I am stuck with the following and would be grateful if you help me out:
    How to calculate the option premium cost – should it be like
    1) “premium%*number of contracts*value of contracts*time period for which option is required” – in this way it is calculated in SA Article on Interest rate management (sept 2011)
    or should it be calculated as:
    2) “premium%*value of loan being hedged*time period for which option is required” – in this way it is calculated in Kaplans final assessment Q3 or past paper for Dec 06, FNDC plc
    or those are different situations for which each of the formulas are applicable?
    Thank you very much
    Olga


    avatar
    koolliver
    Participant
    • Topics: 9
    • Replies: 18

    Someone help here too. I need kaplan.final assesment at kooliver@hotmail.com . Plz send me . Thanks in advance


    Profile photo of John Moffat
    John Moffat
    Keymaster
    • Topics: 3
    • Replies: 8043

    The first method is correct, but be careful (see below).

    The point is that there are fixed sized contracts, and therefore although you want to hedge the amount of the loan, it will not be possible unless the amount divides exactly by the contract size.

    Also, to get the number of contracts you take the amount of the loan, then you multiply by the length of the loan in months and divide by 3 (because the options are on three month futures).

    When you calculate the premium you take the % from the tables, multiply by number of contracts, and then divide by 3 (again, because they are three months futures).
    That is what Sunil has done in his article.

    The way that you say that Kaplan has calculated it will give the same answer, provided that the loan divides exactly by the contract size.

    Have you watched my lecture on interest rate options?

Viewing 3 posts - 1 through 3 (of 3 total)

You must be logged in to reply to this topic.