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Hi John
Sorry again for another silly question.
All answers you suggest or answers given for the past exam papers include calculation of amounts which takes a lot of time (first multiply, and then divide) and there is a huge chance to forget what should be multiplied on what and/or make an error on a calculator.
Why don’t we just use interest rates to arrive at the effective interest rate? Is there a particular reason why we show the calculations of all amounts? What do I miss?
For example, for options (on borrowing date):
Past exam approach
Libor 7%
Company pays (assume) Libor + 0.9% 7.9%
Strike 94.00
Future 92.97
Exercise? Yes
Loan interest payable
(Assume we had £30m for 2 months) £30m * 7.9% *2 : 12 =£395k
Profit (40 contracts * £500k) (94-92.97) * 40 * £500k * (1/400)=£51.5k
Add premium that we paid when the option was bought (assume @ 0.255%) 0.255% * 40 *£ 500k * (3/12) = £12.75k
Total payment £356.25k
Effective interest rate (£356.25k/£30m):2*12 * 100% = 7.125%Quick approach
Libor 7%
Company pays (assume) Libor + 0.9% 7.9%
Strike 94.00
Future 92.97
Exercise? Yes
Loan interest payable
(Assume we had £30m for 2 months) 7.9%
Profit (40 contracts * £500k) 1.03% (94-92.97)
Add premium that we paid when the option was bought (assume @ 0.255%) 0.255%
Effective interest rate 7.9+0.255-1.03=7.125%Can I use the ‘quick approach’ and still get full marks?
Thank youSorry, when I post it on here the formatting disappears 🙁
If you have watched my free lecture on this then you will see that I show both approaches.
It is fine in the exam provided obviously the question doesn’t specifically ask you to show the $ amounts.
Thank you John.
Yes, I did watch all your lectures and thanks for them and particularly for always explaining the reasoning behind the transactions/approaches/formulae. Unfortunately, a lot of lecturers only teach student to pass exam rather than to know the subject.
Am I right thinking that the second (quick) approach can only be used if we do not have an under/over hedge (the amount we need to borrow = the whole number of contracts) ?
Thank you for your comment 🙂
You are right about what you say about having an over/under hedge.
However, if you are short of time, then just mentioning about the fact that there is an under/over hedge and that forward rates could be used on it (without doing the calculations) will still get you most of the marks. Most of the marks are for proving you understand what is happening rather than for the numbers themselves.
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