Sir in several questions they give a spread of expected interest rate like ” the directors expect the rate to rise or fall by .5%”. In such situations how to we calculate the expected interest rate for calculating the price of options at the start of loan. Thanks

I’ve just wondered why future is always 03 months time. As in Example 6, today is 13 August and she wishes to borrow in September (i.e. 18 Sep)? So why don’t buy 5.6m* 8(length of loan)/ 1 (approximately period from buying the option to the exercising date)?

Thanks for the excellent lecture. However, I’m confused in one area, which is the area that dealt with the September Futures price. When setting up the future’s deal, the dealer was instructed to buy the September Put Future at 94.25 which is not the price quoted at the market on the 13th of August; price quoted was 94.30.

Meanwhile when determining the Future’s price as at September, the 94.30 was recognised as the Future’s price for August.

There is not such thing as a ‘put future’. They are buying put options and the option gives them the right to sell futures at the fixed exercise price of 94.25 on the future date. If they decide to exercise the option then on the date they start the borrowing they buy futures at whatever the price is on that date and immediately sell the futures at the exercise price.

Thanks for the correction; it was indeed a mistake, the intention was to write buying September put option.

But, my concern seems not addressed. I’m keen in knowing the relevance of the price of 94.30. I think that’s the market’s determined September futures price on the 13th of August, except we’re saying that numerous September Futures prices exist amongst which is 94.25.

But if that isn’t the case, why will the company choose to instruct the sale at a lower price of 94.25? Definitely, there’d be buyers because of the low price. But could the company instruct to sell at 94.35, a price higher than the market price? And in our calculation should this figure, 94.35, be recognised?

I wish I have some clarifications because in some questions, you’re confronted with a lot of data & understanding the reason behind each of the data will be quite helpful in addressing the question. Thanks.

I assume that you have downloaded the free lecture notes and therefore you have the date in front of you. I also assume that you have watched the earlier lectures and so you know exactly how futures prices work. Nowhere do I say in the lecture that ‘numerous’ September futures prices exist. There are various exercise prices but that is not the same thing at all – they are the prices (for put options) at which you can fix a price at which you can sell the futures on a future date (just in the same way as exercise prices for exchange rate options).

If you exercise the option it is nothing to do with other buyers. The option gives you the right to sell the futures at the exercise price. Selling the future means you will need to buy the futures, and you will do this if the market price on that date is lower than the exercise price.

I do suggest that you watch again the lectures on both foreign exchange options and on the way interest rate futures work, before rewatching these lectures on interest rate options. I explain in full detail the reason behind each of the figures.

Hi John. Is it true that if we only exercise an interest rate option if the strike price/rate is more attractive than the market price/rate, will the associated future contract always be profitable i.e. a receipt to us (here example 6: 拢34,875 receipt) for interest rate options, and not possibly a loss as in standard interest rate futures (not involving option) or fx futures? And that if I manage to calculate a loss on the interest rate future triggered by exercising an option, that I know I have made a mistake..?

How do we *not* exercise the option? If the actual interest rate turns out to be lower than our maximum limit, we can’t just keep holding on to the put options we bought. We’d have to close that deal eventually. So how is it possible to not exercise the option when the deal must eventually close?

No you do not have to close the deal eventually. The option is the right to buy or sell futures at a fixed price. It is up to you whether or not to use (exercise) that right. If you do, then you immediately buy or sell futures (depending on whether they are call or put options) at the fixed price and at the same time sell or buy futures at whatever the price of them is – just as I show in the lecture. If you don’t want to exercise the right then you do not and the option becomes worthless. In either case you will of course have paid for the option and as a result you might have ended up wasting money!

It is the same with all options. I assume you had earlier watched the lectures on share options and the lectures on foreign currency options?

The calculation leading to 7.34% as the maximum rate. I thought the premium should have been divided by 4 as in the calculation for premium payable. This would have adjusted the answer closer to the effective rate calculated.

Thank You for the lectures Sir. When asked to choose a strike price ,why cant we choose(in this sum a put option) based on the strike price giving us the minimum net cost?

Example 5.75% (94.25) + .19% = 5.94% 5.5% (94.5) + .21% = 5.71% (Choose this one because of overall min cost) 5.25% (94.75) + .48% = 5.73%

Although there would be no point in choosing 94.75, the problem between the other two is that although 94.5 end up giving a lower minimum, if the interest rates move in our favour then we would not exercise the option but would still have to pay the premium which is higher than it would have been had we closed 94.25.

For this reason, it is not a question in the exam of stating what the ‘best’ strike price is, but the marks are for proving that you know how we use options and how they work 馃檪

I had mentioned the min. net cost because i had noticed in one of the kaplan texts that this is the way for determining the optimum strike price.

So this method i showed you earlier, is it valid to practice that or do i have to do the calculations for 2 strike prices and then comment which one to purchase?

Ideally in the exam you should show the results for all of the exercise prices available. However if you are short of time then you will still get most of the marks for showing the workings for one strike price and stating that others are available – most of the marks are for proving that you know how options work 馃檪

There is only ever one LIBOR rate at any one time 馃檪

(If you are asking about questions which tell you LIBOR might go up or down on the future date, then yes – if it wants calculations then you do them twice.)

Yes I meant if it says LIBOR could go up and down. Because this June attempt the same happened. DOing the entire calculation twice is time consuming. :O Its a challenge!.

Yes. The important thing though to get the marks is really to prove that you understand how options work. For this you could choose any strike price provided you then discussed the outcome and the fact that there were others available.

Since we are choosing a strike price of 94.25 because its respective interest rate is the closest to 5.75%, what if the 94.25 strike price isn’t among the options table, do we choose the next best strike price, 94.50 = 5.5%?

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hsnkzmi says

Dear Sir,

Hope you’re doing well. How to we choose the strike price if in the exam we aren’t told?

John Moffat says

Ideally you show the results for each stroke price available (and usually these days there are only 2 in the exam)

hsnkzmi says

Thanks a lot sir

hsnkzmi says

Sir in several questions they give a spread of expected interest rate like ” the directors expect the rate to rise or fall by .5%”. In such situations how to we calculate the expected interest rate for calculating the price of options at the start of loan.

Thanks

ngoquynh1224 says

Hi John,

I’ve just wondered why future is always 03 months time. As in Example 6, today is 13 August and she wishes to borrow in September (i.e. 18 Sep)? So why don’t buy 5.6m* 8(length of loan)/ 1 (approximately period from buying the option to the exercising date)?

Thank you very much.

John Moffat says

They are always issued as 3 months futures so the gain or loss is always calculated as though it is 3 months interest.

ngoquynh1224 says

Oh, I see. Thank you very much.

John Moffat says

You are welcome 馃檪

ladesmunic says

Thanks for the excellent lecture. However, I’m confused in one area, which is the area that dealt with the September Futures price. When setting up the future’s deal, the dealer was instructed to buy the September Put Future at 94.25 which is not the price quoted at the market on the 13th of August; price quoted was 94.30.

Meanwhile when determining the Future’s price as at September, the 94.30 was recognised as the Future’s price for August.

Why is this inconsistency please?

John Moffat says

There is not such thing as a ‘put future’. They are buying put options and the option gives them the right to sell futures at the fixed exercise price of 94.25 on the future date.

If they decide to exercise the option then on the date they start the borrowing they buy futures at whatever the price is on that date and immediately sell the futures at the exercise price.

ladesmunic says

Thanks for the correction; it was indeed a mistake, the intention was to write buying September put option.

But, my concern seems not addressed. I’m keen in knowing the relevance of the price of 94.30. I think that’s the market’s determined September futures price on the 13th of August, except we’re saying that numerous September Futures prices exist amongst which is 94.25.

But if that isn’t the case, why will the company choose to instruct the sale at a lower price of 94.25? Definitely, there’d be buyers because of the low price. But could the company instruct to sell at 94.35, a price higher than the market price? And in our calculation should this figure, 94.35, be recognised?

I wish I have some clarifications because in some questions, you’re confronted with a lot of data & understanding the reason behind each of the data will be quite helpful in addressing the question. Thanks.

John Moffat says

I assume that you have downloaded the free lecture notes and therefore you have the date in front of you. I also assume that you have watched the earlier lectures and so you know exactly how futures prices work.

Nowhere do I say in the lecture that ‘numerous’ September futures prices exist. There are various exercise prices but that is not the same thing at all – they are the prices (for put options) at which you can fix a price at which you can sell the futures on a future date (just in the same way as exercise prices for exchange rate options).

If you exercise the option it is nothing to do with other buyers. The option gives you the right to sell the futures at the exercise price. Selling the future means you will need to buy the futures, and you will do this if the market price on that date is lower than the exercise price.

I do suggest that you watch again the lectures on both foreign exchange options and on the way interest rate futures work, before rewatching these lectures on interest rate options. I explain in full detail the reason behind each of the figures.

ladesmunic says

Thanks.

John Moffat says

You are welcome 馃檪

Mahrukh says

Hi John, I was wondering why options are not given directly on interest rates? Jus

Mahrukh says

Just like forex options.

John Moffat says

Because for trading it is better to have a number rather then a %.

Cathal says

Hi John. Is it true that if we only exercise an interest rate option if the strike price/rate is more attractive than the market price/rate, will the associated future contract always be profitable i.e. a receipt to us (here example 6: 拢34,875 receipt) for interest rate options, and not possibly a loss as in standard interest rate futures (not involving option) or fx futures? And that if I manage to calculate a loss on the interest rate future triggered by exercising an option, that I know I have made a mistake..?

felixb1 says

Hi John,

Have understood and am confident in this area so thanks,

my only trouble is say with options there is possibly 4 solutions to do i.e. interest at 7% with two strikes then interest at 5% with two strikes etc.

So my question is in the exam do we have to work out 4 option premium amounts for example?

my difficulty is almost knowing which solutions to do…

thanks

BR

wasimomarshah says

How do we *not* exercise the option? If the actual interest rate turns out to be lower than our maximum limit, we can’t just keep holding on to the put options we bought. We’d have to close that deal eventually. So how is it possible to not exercise the option when the deal must eventually close?

(hope I phrased that properly)

John Moffat says

No you do not have to close the deal eventually.

The option is the right to buy or sell futures at a fixed price. It is up to you whether or not to use (exercise) that right. If you do, then you immediately buy or sell futures (depending on whether they are call or put options) at the fixed price and at the same time sell or buy futures at whatever the price of them is – just as I show in the lecture. If you don’t want to exercise the right then you do not and the option becomes worthless.

In either case you will of course have paid for the option and as a result you might have ended up wasting money!

It is the same with all options. I assume you had earlier watched the lectures on share options and the lectures on foreign currency options?

abayomi says

The calculation leading to 7.34% as the maximum rate. I thought the premium should have been divided by 4 as in the calculation for premium payable. This would have adjusted the answer closer to the effective rate calculated.

John Moffat says

The premium are quoted as annual rates and so are the other rates. So what is in the lecture is correct 馃檪

zhixiang85 says

Thank you John,

On Example 6, I like to ask at what LIBOR rate in 18 September would render the option useless? Would it be anything below 5.75%

Thanks

John Moffat says

No, because the premium would still need to be paid of 0.19%. So it would be anything above 5.75 + 0.19 = 5.94%

ab619 says

Thank You for the lectures Sir.

When asked to choose a strike price ,why cant we choose(in this sum a put option) based on the strike price giving us the minimum net cost?

Example

5.75% (94.25) + .19% = 5.94%

5.5% (94.5) + .21% = 5.71% (Choose this one because of overall min cost)

5.25% (94.75) + .48% = 5.73%

John Moffat says

Although there would be no point in choosing 94.75, the problem between the other two is that although 94.5 end up giving a lower minimum, if the interest rates move in our favour then we would not exercise the option but would still have to pay the premium which is higher than it would have been had we closed 94.25.

For this reason, it is not a question in the exam of stating what the ‘best’ strike price is, but the marks are for proving that you know how we use options and how they work 馃檪

ab619 says

I had mentioned the min. net cost because i had noticed in one of the kaplan texts that this is the way for determining the optimum strike price.

So this method i showed you earlier, is it valid to practice that or do i have to do the calculations for 2 strike prices and then comment which one to purchase?

John Moffat says

Ideally in the exam you should show the results for all of the exercise prices available. However if you are short of time then you will still get most of the marks for showing the workings for one strike price and stating that others are available – most of the marks are for proving that you know how options work 馃檪

ab619 says

Thanks Sir.

John Moffat says

You are welcome 馃檪

aaishas says

Hello Sir,

What do we do when there are 2 libor rates given in question?

Do we do the entire calculation twice for options?

John Moffat says

There is only ever one LIBOR rate at any one time 馃檪

(If you are asking about questions which tell you LIBOR might go up or down on the future date, then yes – if it wants calculations then you do them twice.)

aaishas says

Yes I meant if it says LIBOR could go up and down. Because this June attempt the same happened. DOing the entire calculation twice is time consuming. :O Its a challenge!.

But thanks 馃檨

John Moffat says

When you have done it once, it does not take so long to do it a second time because much of the workings are the same.

aaishas says

kk thanku so much Mr John 馃檪

John Moffat says

You are welcome 馃檪

John Moffat says

Yes. The important thing though to get the marks is really to prove that you understand how options work. For this you could choose any strike price provided you then discussed the outcome and the fact that there were others available.

jesley says

Woah…really? That would be okay too?

John Moffat says

You might lose 1 or 2 marks, but you would certainly get most of them.

mjibola says

Since we are choosing a strike price of 94.25 because its respective interest rate is the closest to 5.75%, what if the 94.25 strike price isn’t among the options table, do we choose the next best strike price, 94.50 = 5.5%?