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Hello Professor,
I have got a question regarding Q79 (The Armstrong Group) from Exam Kit.
When calculating premium for collar when the interest rate increases by 0.5%:
Buy call option (floor) – 100 – 97= 3% , premium 0.032
Sell put option (cap) – 100 – 96.5 = 3.5% , premium 0.123Premium:
(0.123 – 0.032) % * 50 * 1,000,000 * 3/12 = (11,375)
this is an upfront cost that we have to pay but in the answer it is actual a benefit to us.
Why premium calculated in this example is not a cost?
Thanks for your help.
I do not know which Revision Kit you are using. I only have the current edition of the BPP Revision Kit and there is no question 79 (and no question Armstrong Group).
However, I do have the original exam question and there is a net benefit, not a cost.
They are selling a put option and receiving a premium of 0.123. They are buying a call option and paying a premium of 0.032.
Therefore there is a net receipt of 0.123 – 0.032. The rest of your workings are correct but the 11,375 is a net receipt, not a net cost.
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Hi Professor,
I’m using Kaplan Exam Kit 2018/2019.
So I understand it correctly:
If we are borrowing the money we are paying a premium an upfront cost (difference between cap and floor)
If we are investing/depositing money we are receiving a premium (difference between cap and floor). Is this correct?
Thanks
We pay a premium when we buy an option (whether we are buying a put option or a call option) and we receive a premium when we sell an option (whether we are selling a put option or a call option).
The net premium the difference between the premium received and the premium paid. The difference might be a net receipt or might be a net payment – it depends on the exercise prices and the respective premiums.
Have you watched my free lectures on this?
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Thank you professor.
I’ve been using the knowledge form the Kaplan course that I took but the hedging deposit using collars was not covered. There is not much on the topic in the book either so I was not sure how to solve it.
I will definitely watch your free lecture on this topic.
Thank you again for your help.
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