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Sir can you please tell me in b part of this question from where is this interest rate 4.25%,4.25% and 4.50% coming.Thanks
From the strike prices. A strike of 95250 is really 95.25, which is equivalent to 4.75% (100 – 95.25).
A strike of 95500 is 95.50 which is equivalent to 4.5% (100 – 95.50)
Similarly for 95750.The free lectures on interest rate options may help you.
Thank you sir, i understand that but still the question is not clear.
libor is currently 5% and the company can invest at libor minus 25 basis point
Strike price in question r
95250
95500
95750and in solution three possible collar combination
call strike price put strike price interest rate less.25% less call prem addput prem net
95750 95500 4.25
95750 95250 4.25
95500 95250 4.50i understand everything apart from this interest rate please have a look n explain. Thanks
The company is investing money and therefore it is buying a call option that fixes the maximum interest rate.
So the first two involve a strike price for the call option of 95.75, equivalent to 4.25%.
The third one has a strike of 95.50, equivalent to 4.50%. These would be the minimum interest rates that they would receive subject to what follows.However, to those minimum equivalent interest rates we need to subtract 0.25% (because options vary with LIBOR and they can invest at 0.25% less than LIBOR) and subtract the premium payable for the call option. However, with a collar, provided they are prepared to accept a maximum interest rate they can sell a put option, and so we need to add the premium they will receive from that.
The final column therefore shows the minimum net interest they will end up effectively receiving.
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