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Hi John,
put option with strike of 95.50 which means interest rate of 4.5%, the libor increase to 3.6+0.8=4.4. as libor is lower than strike, we should not exercise the option, is it right? Examiner’s answer is Yes to exercise the option, why should we exercise the option to pay 4.5% while we could borrow at 4.4%. The company needs to pay libor+0.7=5.1%, but I thought whether we exercise the option only depends on the libor not actual rate the company needs to pay. Can you please help, do I misunderstand the concept again? Thanks.
Interest rate put options are the right to sell interest rate futures at a fixed price.
If libor increases to 4.4% then the equivalent futures price would be 95.60, but because of basis risk the actual futures price is estimated to be 95.44 (as per the answer).
Therefore they would exercise because exercising would mean buying futures at 95.44 and selling them at the strike pf 95.50, which would make a gain.
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