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Hi John, I have been working on Qn 1 from June 2014 and also watched your lecture on this and noted that both your workings and examiner’s model answers didn’t take into account gain on futures contract. From my understanding, again of CHF 3,559 [(1.0659-1.0651) x 38 contracts x CHF 125,000/US$1.0677] should have been recognised.
Is there any reason why this wasn’t taken care of?
Thanks.
It is because we have used the lock-in rate which is the net effect of translating at whatever the exchange rate is on the date of the transaction combined with the gain or loss on the futures.
I don’t know if you have watched my recent lecture explaining what the lock-in rate it, but if not then that should make sense of what I am writing above 🙂
Many thanks John.
On another note in the same question while evaluating the option, model answer exercised the options in all the strike prices.
However, my analysis shows that at exercise price of $/CHF 1.06, it would be cheaper to lapse the offer and convert at spot rate (assuming forward rates is the best prediction of spot rate in 4 month’s time), this would give a cost of CHF 4,739,159 compared to CHF 4,773,585.
Grateful for your guidance on this.
If you have time then you should consider all strike prices and then comment.
However, if you are short of time, the main thing is to prove that you know how options work – even if you only consider one strike price you would then get more than half of the marks for that part.
Many thanks John,
My question is why exercise the option at strike price of $/CHF 1.06 instead of lapsing and using the spot rate on transaction date?
But we do not know what spot will be on the transaction date. (It will not be the current spot, and it has nothing to do with the futures lock-in rate.)
So all we can do is show what the worst that could happen is when using options.
Many thanks John.
Would it be wrong to assume that the forward rate (1.0677) given in the question would be a good estimation of spot rate on transaction date?
In Polytot (SFM, June 2004) BPP kit Qn. 85, the forward rate was used as the spot rate on transaction date to predict the futures price on transaction date.
You would probably not lose any marks for doing that (as long as you wrote it as an assumption – the forward rate is always based on interest rates and is never a prediction of the spot). The marks for the options are really for being able to prove you know how to work, and to be able to make the point that the big difference between them and other ways is that you are able to get the benefit of spot moving in your favour (which does not happen with the other ways) but that there is a premium payable regardless (which there is not with the other ways). Just explaining that will normally get more than half the marks, even without the numbers 🙂
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