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In b part the que says- is considering and assuming that the co does not face any basis risk. What does this line mean? What it has to with que.? What will be affected if there is basis risk?
Also in the same que, in b part answer, they have written go short in the futures market
What is short here?
We do long call and put, so here we should have done long put futures.
We do short only in collar.
Please explain what they meant by short?
Also for clarification please explain diff between short and long.I assume that you have watched my free lectures and that you are therefore happy that we always assume in exam questions that the basis falls linearly to zero over the life of the future. In practice there is no reason why the relationship should be linear and therefore the actual results may be different from the result we predict. This creates an element of risk and it is called the basis risk.
Going long is buying now and selling later. Going short is selling now and buying later.
But in short call and put we receive premium, so here we were buying call option so it should have been long call?
It is in the futures market that they are going short – they are selling futures now and buying back at the end of the deal so as to hedge against a rise in interest rates. There is no premium involved when dealing in futures.
As far as the options are concerned in part (a) they are buying a call option (so paying a premium) on futures so as to protect against a rise in interest rates. If they create a collar they will also sell a put option on futures (so receiving a premium) – they reduces the net cost but limits the benefit if interest rates fall.
Have you watched my free lectures on the management of interest rate risk?
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