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How do you determine when to exercise an option or not incase of a borrower or a lender?
And is there always an overhedged amount and are we always supposed to calculate it? And do we always hedge it against the forward rate given?
You really need to watch my free lectures on interest rate risk management – I cannot type out all the lectures here 🙂
If you are borrowing money, then you will buy a put option which is the right to sell futures at a fixed price. You will exercise it if the futures price on the date of the transaction is lower than the exercise price (so you make a profit by exercising it) which will happen if the interest rates are higher than the interest rate that is equivalent to the exercise price.
I do explain all of this in my lectures, with examples.There is not always an over or under hedged amount, but there usually is because of the fixed contract size. It is a fairly minor point in the exam – ideally, since we know in advance what the amount is, you would hedge it using forward rates. However if you are short of time, just mentioning the idea (without calculations) would still get most of the marks.
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