Casaphobia June 2011

With options, you cannot predict the final outcome (because with knowing the spot rate you do not know whether or not they will be exercised). However, you can (and must) explain what the worst outcome would be at the various strike prices. With regard to bullet points in the report, be careful. It is OK in (for example) your section on assumptions (which you are almost always asked to state), but otherwise try and avoid it. It doesn't mean writing more - still list the various points you are making but try and make them sentences and don't put bullet 'marks' against them.

Sir, thank you for your prompt reply. I really appreciate. However, I am still not clear about the following: 1) How to determine the worst outcome? Should we stop at the premium calculation? Could you please illustrate with Casaphobia exam question? 2) Can we assume that the lock in rate is the spot rate on the date of transaction? 3) Or can we take the forward rate as the spot rate on the date of transaction? But what if forward rate is also not given in the question? I think if you could please illustrate with the exam question, things will be clearer in my mind. Thanking you in advance.

I will answer your questions, but I do really not have the time to type out answers to Cassasophia (everything is explained with examples already in the free lectures). 1. With options the worst that can happen is that the option is exercised and so the worst outcome is whatever will happen if it is exercised (and therefore conversion is at the strike price) plus the cost of the premium. 2. The lock-in rate is certainly not the spot rate at the date of the transaction. It is only relevant for futures and is the net effect of converting at whatever the spot turns out to be and the gain/loss on the futures deal. 3. The forward rate is unlikely to be the spot rate on the date of the transaction (if it happens to be then it is just a coincidence). With foreign exchange options, if you are told the spot rate on the date of the transaction then you use it. If you are not told then state the worst outcome as explained above. Again, I do really suggest that you watch the relevant lectures. (Also, of course, when it comes to interest rate options, then things are a bit different because they are options to deal in futures.)

Apologies for being adamant but I want to get it right. Also, please rest assured that I have gone through all your lectures including the recent ones such as the lock in rates. I have the following answer when working the questions: Buy 118 call options contracts at 1.36. Total premium at today's spot is Eur 303,275 (pay) It is the calculation for net payments/receipts that I am stuck because the example at open tuition gives the spot on the date of the transaction. Grateful if you could, plese, confirm if the below is ok: Assume that the option is exercised. The worse outcome will be: Calculation for net receipt: Transaction: $20M/1.36(exercise price) =14,705,882 (rec) Less premium paid today = (303,275) (pay) Net receipt =14,402,607 (rec)

Yes - that is correct :-) But also do make the point in the exam that this is the worst outcome, and that if the exchange rates move in our favour then the option will not be exercised at the outcome would be better, but stress that the premium would still be payable whether we exercise or not :-)

Phew!! Thanks a lot. You really are a great tutor. I have attended tuition with a gold approved provider. I can and am testifying that it is the open tuition lectures that helped me grasp and understand P4!!

Thank you very much indeed for your comments :-)

Hi John, In cassasophia, when calculating the futures rate, the examiner and mine answer is different. According to me, 1.3633+ ((1.3698-1.3633)/5 *2)= 1.3659 What the examiner did was, 1.3698-((1/3* (1.3698-1.3633))= 1.3676 If you see in lammer plc, the rate is calculated the same way like I did. Please help me out.

Your method is fine, but you have used the wrong figures!! There is 3 months between the 2 month futures and 5 months futures. Therefore to get a 4 month future you need to take the 2 month futures plus 2/3 of the difference (not 5/3). 1.3633 + ((1.3698 - 1.3633)/3) x 2) = 1.3676