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Choosing the strikes to hedge interest rates

Forums › Ask ACCA Tutor Forums › Ask the Tutor ACCA AFM Exams › Choosing the strikes to hedge interest rates

  • This topic has 1 reply, 2 voices, and was last updated 2 months ago by John Moffat.
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    Posts
  • May 15, 2022 at 5:36 am #655662
    taskmaster
    • Topics: 19
    • Replies: 13
    • ☆

    Hi John,
    I have some confusion in choosing strike to hedge interest rates.
    My logic is:
    For call options = (100-strike price)-premium and choose the strike with the highest value
    For put options = (100-strike price)+premium and choose the strike with the lowest value

    Is my understanding right?

    May 15, 2022 at 9:57 am #655677
    John Moffat
    Keymaster
    • Topics: 57
    • Replies: 49921
    • ☆☆☆☆☆

    No. The problem is that although different strike prices will result in different maximum or minimum effective interest rates (depending on whether call or put options), the premiums will be different (and the premium is of course ‘wasted’ but will still have been paid even if the option is not exercised).

    Ideally in the exam you should show the effect for each of the strike prices available (and usually these days there are only two). If you are short of time, then just showing for one of them will get more than the half marks needed (because the examiner is more concerned that you can prove you know how options ‘work’).

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