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Hi Sir,
i did a few questions and examiner answer and bpp answer is kind of different
Scenario 1: Questions gave a spot rate, determine whether to exercise or lapse.
Examiner: used forward market hedged to hedge over/under hedged portion.
BPP: exercise at spot rate, calculated the option outcome(difference between spot and strike price)both answer will be difference by hundreds.
and i find there’s a flaw in BPP answer. If i were to lapse the option. why will there still be an ‘option outcome’? it is not like futures, i got to close my position.i faced this problem when i was doing (autocrat, dec’02) part c
There are two ways that you can illustrate how options work.
Strictly it should be the BPP way – convert the transaction at spot, and calculate the profit on the options.
The alternative is to just convert the option amount at the spot rate.
Both ways get full marks (even though they do not always result in exactly the same amount).In both cases, the amount of the options will not exactly correspond to the amount of the transaction because of contract size. So in both cases it is at least good to mention that the over/under hedge could be covered using the forward rate.
With regard to the question Autocrat, I do not have the latest BPP Revision Kit and the question does not appear in my copy (which is the previous one), and so I cannot comment on the ‘flaw’ that you mention. Certainly, if the option is not exercised then the only cost involved is the cost of the premium.
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