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Dear Sir,
is there any general rule for choosing the price for call option and put option in interest rate collar?
if we look into the following question from kaplan exam kit DAIKON CO (JUN 15) and THE ARMSTRONG GROUP (SEP/DEC 15). The former one relates to borrowing of money and latter one relates to depositing of money.In both the question, we take low exercise price for put option irrespective of whether we are buying the put option or selling the put option and vice versa for call option. Would it always be same in all the scenarios?
Yes i have taken your all AFM lectures but could not get this point. could you please elaborate it and tell me that specific rule. i would be grateful to you.
Thanks
The ‘rule’ is as you stated in your initial post, which I confirmed was correct.
If you are borrowing money you want to limit the maximum interest rate and to do that you buy a put option. The higher the exercise price the lower the effective maximum interest.
If you create a collar in order to reduce the net premium payable, you sell a call option which limits the minimum interest rate. The lower the exercise price the higher the effective minimum interest.
Given that the maximum interest must be higher then the minimum interest, the exercise price for the put option must be lower than that for the call option.
If you are investing money you want to limit the minimum interest rate and to do that you buy a call option. The lower the exercise price the higher the effective minimum interest.
If you create a collar in order to reduce the net premium payable, you sell a put option which limits the maximum interest rate. The higher the exercise price the lower the effective maximum interest.
Given that the maximum interest must be higher then the minimum interest, the exercise price for the put option must be lower than that for the call option.
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