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Why in answer scheme it say that “options on future or collar hedge will change net cost”? I think the net cost for all the derivatives changed ? What does it means by that sentence ?
What is meant by this statement is, that interest rate futures and forwards in a way fix the interest rate payment at a certain percentage (in this case it’s 4.47% for futures), i.e. no matter how much interest rate fluctuation happens in the bond market, the net interest payment will be at 4.47%(considering all the assumptions like no basis risk, transactional costs, etc. hold true).
In contrast, a change in the market interest rate of bonds will result in a change in the net interest payment while using collars and options. If the market interest rate favors the option buyer, he will let the option lapse; if it does not, he will exercise the option, changing the amount of net interest that must be paid in both cases.
With regard to the first paragraph, that is the whole points of using futures – that the net effect of paying whatever the rate of interest turns out to be together with the gain or loss on the futures, is fixed whatever happens (subject to basis risk, contract size etc.)..
I explain and illustrate this in my free lectures!
Options just fix a maximum or minimum interest rate (depending on whether borrowing or depositing) . If the option is not exercised then they will pay or receive whatever the actual rate turns out to be.
Have you watched my free lectures on the management of interest rate risk?
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