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The main disadvantage is that the benefit from any upside movement in interest rates is
capped by the sale of the call option. With just the put option, the full upside benefit would
be realised.sir did not understand this point?
You are quoting from the BPP answer and what they have typed is wrong (and is not what the examiner typed in his answer).
What the examiner wrote is this:
“However, the main disadvantage is that, whereas with a hedge using options the buyer can get full benefit of any upside movement in the price of the underlying asset, with a collar hedge the benefit of the upside movement is limited or capped as well.”Interest rate options are options on futures, and the underlying asset is therefore the future.
The company is borrowing money and therefore wants to be protected against increasing interest rates. If interest rates increase the the futures price will fall, whereas if interest rates fall the the futures price will increase.
Buying a put option allows them to get the full benefit of any increase in the futures price (and therefore a fall in the interest rate), but limits any increase in interest rates.
Creating a collar and therefore also selling a call option limits any upside movement in the future price and therefore limits any fall in the interest rate.Have you watched my free lectures on options and collars? 🙂
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