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hi John good day. i want to ask a question with regards interest rates options and i will use the Dec 2014 exam question. the following information was given
March calls Strike price March puts
0·882 95·50 0·662
0·648 96·00 0·902
in the question it said interest rates may rise or fall by 0.5. it is certain that a put option will be bought if we want to hedge against a rise in interest rates.
my question is this, if interest rates were to fall we won’t even hedge but when i look at the answer the calculation was done. I want to ask if a candidate will still get the marks if he/she just wrote no hedge will be done for a fall in interest rates
my other question is this: in all the past exams where such a question has been asked, calculations have been done for both prices. but i know that if we compare the 2 strike prices, we see that 96.00 is the price we will go for. is it required to do the calculations for both prices or can one just compare the 2 prices and their premiums and then choose the one that will be more advantageous
thank youIf we knew in advance what the interest rates were going to be then we would not be doing any hedging – there would be no point.
The reason for using options in the first place is because we do not know in advance what will happen.
You will only find out later what happens to the interest rate and you would get no marks for saying that you would not hedge.
i asked two questions. the other question was with regards to the strike price to choose. in the solution to past exam questions, the calculations have been done for both strike price before stating the one that is better. what if i choose the better option (comparing the strike price with the pemium) and do the calculation only for it
If there are several strike prices then ideally you should show the calculations for all of them and then state why one may be preferable to others.
However, if you are short of time what is most important is to prove that you know how options work – doing it for just one strike price will normally get half the marks for that part of the question, because you will have proved that you know how they work.
You are welcome for my answer to the first part of your question!!
I am on vacation which is how I missed the second part – I had jet lag after flying for twelve hours.
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