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Dear Lecturer,
Quick question and sorry if it is silly or has been answered – I had a quick look but didn’t come across it.
If the question states that you have two options on futures, say 95.50 and 96.00, and after doing the calculations you decide that 96.00 is the better option, why then when calculating the collar, do we use 95.50 as the put option and 96.00 as the call option? Surely you would buy the put at 96.00 and sell the call at 95.50?
Thank you in advance for your response!
Hi sorry – I have come across it before therefore I thought it was a principle being applied.
An example would be June 2015, Question 4 (a)
Thank you
I could not answer your original question because you did not say whether the company was borrowing money or depositing money!!!
If they are borrowing money then they will buy put options and sell call options to create the collar (as in June 2015 Q 4) because they want to create an interest rate cap but at the same time accept an interest rate floor in order to save on the net premium.
If they are depositing money then they will buy call options and sell put options in order to create the collar, because they want to create an interest rate floor but at the same time accept an interest rate cap in order to save on the net premium.My note on interest rate collars will help you (it is linked from the main P4 page).
Hi John,
I understand how the collar works, but what I dont understand is when we already calculated that the 96.00 PUT option is better (we are lending money), why when we create the collar, do we use 95.50 as our PUT and 96.00 as the CALL to create the collar?
Using 96.00 as the put and 95.5 as the call gives us lower finance charges than doing it the other way around as stated in the examiners answers (even with the higher premium).
Sorry if I am wasting your time by not seeing something that is obvious 🙁
Just a correction to the above – we are borrowing money 🙂
Written before my first cup of coffee…Firstly, (forgetting the collar for the moment) we do not know that a put option at 96 is better.
Certainly if interest rates to go up by 0.8% then 96 turns out to be better, but if (for example) things go differently than they expect and interest rates actually fell, then 95.50 would have been better (neither option would be exercised at the premium on 95.50 is much lower).
We can never say in advance what the best strike price to go for is – it is only later when we find out what has happened to interest rates that we will find out. All we can do is recommend based on what we think might happen.With regard to the collar, buying a put fixes a maximum interest rate (95.50 effectively fixing it a 4.5%), and selling a call fixes a minimum interest rate (96.00 effectively fixing it at 4%).
So because (when borrowing money) the maximum must be more than the minimum, it means that for a collar the strike price of the put has to be lower than that of the call.(You can of course buy a put and sell a call, both at the same strike price. However this would no longer be a collar – it would be a way of effectively fixing the interest rate.)
Hi John,
We knew it was better at 96.00 because we already calculated it. Even though it was not the best option and therefore not the one we would have selected, the question around the collar followed on that. I was looking at the calculation from a ‘worst expected case scenario’ and which option would minimize the possible cost payable if it materialized.
I was viewing the purchase of the put and the sale of the call as two completely separate transactions and under the assumption that we are trying to mitigate the cost if what we are expecting to happen, happens.
Your statement above (‘the maximum must be higher than the minimum’) clarifies it to me however as I was not viewing it as ‘one’ transaction.
Thank you for the assistance! I appreciate the time spend. I have not had a lot of time to study so I am trying to ‘understand’ things rather than just ‘learn’ them and it bugs me if something does not make sense.
Enjoy the rest of your day! 🙂
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