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in collar options how do i decide which exercise price to choose to buy and to sell??
It woulld be really helpful..Thanks
In an ideal world you would look at all combinations of the exercise prices available.
Each of them would result in a different collar, with a different net premium.
You could then discuss which seemed better or worse.However for most of the marks you need to prove you know what a collar is, and for this choose any two exercise prices. There is no rule.
the extract of the question
:Troder plc expects to have 400 mil available for s/t investment for 5 months commencing in 2 months time. the co. wishes to protect it from any fall of interest rate and also would like to benefit from any rise in interest. again it is concrned with the high premium. use of collar option is suggested.
LIFFE Sterling options (500,000)strike price call put
95.25 .445 .085
95.5 .280 .170
95.75 .165 .305libor is 5% Co can invest at LIBOR minus 25 basis points
req: company wishes to receive more than 6750000 in interest from the investment after paying the premium. Illustrate how the collar option would be used??..IT SAID IN ORDER TO ACHIEVE A RETURN MORE THAN 4.05% A COLLAR NEEDS TO BE ARRANGED WITH THE CALL STRIKE PRICE HIGHER THAN THE PUT STRIKE PRICE…WHY???.i apologize for the big question 🙁
If you are investing money, then buying a call option will limit the minimum interest rate. (Because if you have a strike of (say) 95, then if interest rates are lower than 5% then futures will have a price of more than 95 so exercising the option will give a profit to ‘cancel’ the lower interest – so it will fix minimum interest at 5%).
Selling a put option will (in a similar sort of way) fix a maximum interest rate. So (for example) selling a put with an exercise price of 92 will fix the maximum interest at 8%.
Because with a collar you are always fixing a maximum and a minimum interest rate, then if you are investing money you will always want to buy a call with a higher strike than that of the put.
(Have you watched my lecture on collars? They are covered in the first of the lectures on interest rate risk.)
Dear sir,
Can you please explain to me the question
b. (ii) Estimate the maximum interest that could be received with your selected hedge.
The answer in BPP is: “The maximum interest rate that is possible under the selected hedge is 4.75%, equivalent to the put option exercise price of 95250. Troder will not have exercised its option, but taken advantage of the rate being above 4.5%.
Net return = 4.75 – 0.25 – 0.280 + 0.085 = 4.305%”It would help in future if you would give the name of the question! 🙂
Because they are investing money, they are creating the collar by buying a call option and selling a put option.
Selling the put option fixes the maximum interest received at 4.75% (equivalent to the exercise price 95.25) . They will also have had to pay a premium for the call option of 0.280% and received a premium from selling the put option of 0.085%. Finally, from the question, the interest they receive is always 0.25% less than LIBOR.
The free lectures on options, together with the extra note that I have written on collars, will help you.
Dear Sir,
Thanks for your quick response!
My concern is that: premium for the call option of 0.280% is applied for interest 4.5% not 4.75%.
While premium for call option @ 4.75% (strike price 95.25) is 0.445%.The examine has created a collar by buying a call option at 95.50 (limiting the minimum interest to 4.5%) – the premium payable for this is 0.280%, and selling a put option at 95.260 (limiting the maximum interest to 4.75%) – the premium receivable for this is 0.085%.
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