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Dear John,
I have got two issues that confused me.
1. M&A
In the question of J13Q2 and D12Q3, the question has very similar requirements to ask us to calculate the percentage gain/premium per share, under three very similar payment method (Cash Offer, Share-for-share exchange and bond offer). However, the answers given by the examiner varies in the treatment of Share-for-share exchange and Bond offer.
In J13Q2, the examiner did not work out the combined share price (synergy included) and the Market Value of bonds, whereas in D12Q3 he did.2. Risk mgt
For interest rate risk management, when there are two or more stike prices, which one should I choose? And in the marking scheme (D14Q2), it says “Option contract calculations” second exercise price (or justification for calculations of just one exercise price)”. What am i supposed to write if I’m gonna just use one strike price?BTW, thanks a lot for your great efforts in helping us advancing our professional career!
Thanks John! Thanks Opentuition Team!1. It is a bit confusing I appreciate (and given it is P4, you would get the marks for different workings because so much depends on assumptions).
The reason is that in one of the questions you are looking at how much the acquirer would be willing to pay, whereas in the other it is more a question of how much the sellers would be prepared to accept. The acquirer has more information about things like synergy benefits, which the seller does not have.2. With options it is usually impossible to say which is best. The reason is that different strike prices give different limits as to the worst outcome, but the lower the limit the more expensive the option is (the premium).
Obviously, we don’t know in advance what will happen to the interest rate. If is does increase, then the option will be exercised and the lower the limit the better. However, if the interest rate moves in our favour, then the option will not be exercised, but the premium will still have been paid.
In the exam, most of the marks are for proving that you know how options work (even if you only look at one strike price). For perfect marks it is then a question of looking at all the strike prices and discussing between them – not for picking one as being ‘the best’
🙂Dear Rick, the way I would approach the selection of the Strike Price is by determining whether it is a Put or a Call Option. I normally choose the Put options prices that gives me the highest receipt and the Call Option which gives me the lowest interest payment. If it is a Put Option, the net receipt will be interest receipt less premium paid for the option and Call Option the net payment would be Interest plus premium.
Remember that any seller would always like a price that gives him/her maximum receipt and any buyer would like to pay the lowest possible price.
Thanks.
Opiod: Please of not answer in this forum – this is the Ask the Tutor Forum and you are not the tutor (but please do help people in the normal P4 forum by all means 🙂 )
Also, what you have written is simply not true. What you say about the net receipt is only relevant if the option is exercised, but since that attraction of options is that they are effectively ‘insurance’ against the exchange rate or interest rate moving against you (because you feel the the exchange rate or interest rate will move in your favour), then if they do move in your favour and therefore you do not exercise the option the only relevant factor would have been the amount of the premium!!
My previous answer is what is relevant for the exam!
Dear John, I understand what you said about M&A, it’s mainly due to informatio asymmetry. There is no absolute right or wrong answer, as long as we can base our answer reasonably on relevant P4 knowledge, and demobstrate our thoughts. There will always be marks available.
Thanks John!
Still, about the use of Option in risk management, there are always marks for calculation (or explanation) of second exercise price, either in Forex or interest rate risk.
What am I supposed to explain for the second exercise price if I do not calculate?If you have the time, then ideally you should do the calculations for all of the strike prices (unless obviously the question directs you otherwise). In fact, once you have done it for one, the others should usually be quite quick because the basic workings are the same.
However, given the time pressure the most important thing is to prove that you know how they work. If you are short of time then certainly do it for one strike price (and that will get you more than half of the marks for that part), but then make the point that I was making earlier – that because we don’t know in advance what will happen to the exchange rate (or interest rate) that other strike prices will give a different ‘worst outcome’ but will have different costs (which will be payable whether or not the options are exercised).
In that way you will have proved to the marker both that you understand the calculations for options and that you also understand the potential benefit of options (in that they fix a worst outcome but allow you to get the benefit of exchange rates or interest rates moving in your favour).
Hi John, thanks a lot!
Now I understand the whole key point about using options with risk managenent question will be to fix a worst outcome and this has been explicitly demonstrated by the Interest Rate Collar.Thanks a lot for your kind sharing and consistent efforts in keeping sharing free resources!
Wish you all the best!
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