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Hi John,
Hope all is well.
Could you show me how you would approach the part (b) to the question indicated in the topic title to this discussion please, specifically the option part of the question.
I am able to identify every aspect of the option used:
– Buy December Calls
– 50 Contracts (25m * 6/3)
– The premiums for the two strike prices quoted in the option tableI don’t understand what strike price we will use, as well as how to tackle the question mentioning the +0.5% increase or decrease in interest rates. When I watched your online lecture on interest rate options, you calculated the strike we would use based on the current LIBOR rate. However, when I try to do this for the current LIBOR in this question at 1st September (100-3.6%= 96.4) I don’t see this in the option table to use. Also, how do we proceed when they don’t tell us the future interest rate?
Thank you in advance
Disregard this please, I made an error. The corrected question is above. Sorry about that.
John I think it posted the same question twice.
My amendment to the question was the 3rd last line:
(100- 3.6% +/- 0.5% = 95.9 and 96.9)
(I believe these will be the strikes we want to look for because it’s LIBOR + 0.5% and LIBOR – 0.5%.)
The whole point of using options is to protect against a fall in interest rates (the options limit the lowest effective interest rate) while getting the benefit of an increase in interest rates (because then the option will not be exercised).
Choosing a strike price of 96.50 will limit the lowest interest to 3.5% (less the premium payable), whereas choosing a strike price of 97.00 will limit the lowest interest to 3% (again less the premium payable).
We know that LIBOR will increase by a maximum of 0.5% up to 4.1% or fall by a maximum of 0.5% down to 3.1%. For both of these we can calculate what will happen to the futures price and therefore for each of the two available options we can decide whether or not they would be exercised and what the resulting effective interest rate will be.
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