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Hello John,
I’m trying to solve a question on collar hedge. Please how did they get interest rate to be 4.25%? Because libor is 5% & it says libor minus 25basic points
Also on collar, they did three possible collar combination, can we do just one in exam?? (it is a call options cus we don’t want a fall in interests rate)
The interest rates listed as 4.25% are those determined by the call strike price of 95.750.
(100 – 95.750 = 4.25)Ideally in the exam you will look at all of the collars that are available, and discuss.
If you are short of time, then certainly just showing one of the collars (and discussing) will get you most of the marks.I do suggest that you read the note I have written about collars – it is linked from the main P4 page.
Thank you. Found it
Just finished watching the video on FRA and am trying No 56,AWAN Co (bpp kit). Please am I right in this
1) If we are receiving money from the bank, we want interest rate to increase, so (a) if fra increase than the agreed rate, we pay the bank the differences (b)if fra decrease the bank pays us the differences
2)if we borrowing, we want interests rate to decrease so (a)if fra increase the bank will pay us the differences (b) if fra decrease we pay the bank
Dear John,
same Troder question on collar question b. I have difficulty to uderstand how the logic behind the selected interest rate in net receipt calculation.
We are net borrower and calculate net receipt rate of the collar. This is basically 1 call option and 1 pull option.
Clear that we have a net of 2 premiums to pay (the aim of the collar is to reduce the premium to pay), and that on that aspect, choosing one cap or another will impact the result.
Now for interest rate selection in the calculation, it seems to come from the call strike price (the floor option), which defines the minimum interest rate we will receive. Choosing one cap (put strike) or another has no impact on this interest rate ? Why don’t we have anemone variable in this calculation ?
Thanks for your kind help.
I don’t understand why you should want another variable – what for?
There is only one variable involved and that is what the actual interest rate turns out to be – that is obviously outside our control.
The whole purpose of the collar is to fix what the effective maximum and minimum interest rates will end up being (the end result will then be somewhere within the range depending on what the actual rate turns out to be). Which two strike prices to choose is up to the company to decide (there is no rule as to what to choose) and depends on a combination of what limits they prefer to set, and the net cost (given that the net cost will be payable whether or not the options end up being exercised).
Hi john,
For Troder one of the Possible collar option is is to buy December call option at 95.75 or 4.25% and sell december put option at 95.50 or 4.5%.
Net premium=.165-.170=.005 received
Current september libor is 5 0r 100-5=95here how do we going to estimate the future price on late october when we are going to do the actual transaction.As the question does not says by how much the libor is expecting to be decrease or what is the current september future price is or we just assume estimated future price is going to be 95 as well.
in that case Troder is not going to exercise the call option but Buyer of put option is going to exercise it as interest has increased.
so
Actual receipt for troder 5-.25 =4.75
loss on call option 95.5-95 =(.5)
Premium receipt =.005
Result is still incorrect.
Normally we use the basis risk to estimate the future price but dont know how to get basis here.I hope you understood the way i deal with futures please provide me a solution on how i can apply this concept for this question or it is not possible to do this way.Please help.It is impossible to estimate what the actual interest rate will turn out to be, or what the futures price will be – there is not enough information.
But this is not required in the question.The question is wanting you to prove that you understand what a collar is – i.e. fixing a maximum and a minimum effective interest rate, and stating what the maximum will be.
On the collar you describe, whatever the actual interest rate turns out to be, the maximum they will receive is 4.5 + 0.005 – 0.25 = 4.255% and the minimum they will receive is 4.25 + 0.005 – 0.25 = 4.005%
(The 0.25 is subtracted because options and future vary with LIBOR, and this company gets 25 basis points less than LIBOR. In practice the final outcome will be a little different because of basis risk, but we cannot deal with that here because we do not have the information.)
so the interest rate floor is 4.005 and upside benefit of interest rate is capped at 4.225.
So the Interest rate is collared between 4.225 to 4.005.Am i correct John.
But why the answer is using the minimum rate of 4.005.Because the question says that they want to earn a minimum of $6.75M. So the minimum rate fixed by the collar needs to give them at least $6.75M
By The way am is my statement above is correct regarding interest rate collared between 4.225-4.005.Thanks.
What a relief!
This question nearly gave me heart attack last night. I spent hours on end trying to make sense out of the logic without success.
I came to the forum to vent my frustration only to see these explanations.
Delaidesvp and Dewan, Thank you for extracting this lucid explanation from Prof after bombarding him relentlessly with questions.
Prof. John Moffat, Thank you very much for always being there for us.
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