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i dont understand ow to use this. in particular the bbp question # 77 Troder.
to protect against a fall in interest rates how would you hedge using a collar?
please look @ the question and advise how to proceed and why?In the case of borrow. Now let’s say, interest rate is 6% (LIBOR = 94). You worry that interest may arise (LIBOR may go down), therefore you sell the futures (buy put option). To minimize premium, you sell a call option (interest at 4%, LIBOR = 96). Later, If interest above 6%, hedging successful; If interest between 4% and 6%, both you and your counter party lapse the option contract; If interest below 4%, your counter party exercise call option, you lose on option market, but gain from reduction in interest expense.
In the case of deposit. Now let’s say, interest rate is 4% (LIBOR = 96). You worry that interest may fall (LIBOR may go up), therefore you buy the futures (buy call option). To minimize premium, you sell a put option (interest at 6%, LIBOR = 94). Later, If interest below 4%, hedging successful; If interest between 4% and 6%, both you and your counter party lapse the option contract; If interest above 6%, your counter party exercise put option, you lose on option market, but gain from increase in interest income.
Collar hedge criteria (“FLOOR” in case of Borrowing and “CAP” in case of Lending) should be specifically given in exams. If we are borrower (7%) and u want max/cap and similarly we set min/floor (5%) to minimize our premium cost….Ideally examiner will tell us that about that min/floor to set set like How collar hedge would be structured at 5%…Am I right????
AQ! The exam does not need to give the criteria for the collar. If there are traded options available at various exercise prices then there are various combinations that you can use to create a collar. Each one would have different limits and a different ‘net’ premium cost.
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