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Hi John, I was doing a question of hedges but got really confused with this. We are hedging a deposit, so we will need to buy call options and sell put options at different exercise prices, right? In this specifc question we need to earn interest of more than 4.05% so we have to try different combinations but it says that call option price needs to be greater than put option price? Why is that? The question is Torder june 2003 by the way.
Remember that as interest rates go up, the price of futures falls.
So…..(for example) buying call options with a strike price of 94 will protect against interest rates falling below 6%. If interest rates fell to (say) 5% then the futures price will go up to 95 and we can make a compensating profit.
To reduce the premium cost we could choose to also sell put options. This would limit the maximum interest. So….if we sell put options at a strike price (say) 92 then the maximum interest would be limited to 8%. Since we must have the minimum interest below the maximum interest, it means we must buy call options with a higher strike price than that of the put options we are selling.
Hope that makes sense 🙂
PS If it helps I have posted a short note about collars on the main P4 page
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