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Hello sir,
Two questions related to hedging.
(1) For a collar hedge, if company wants to keep the maximum interest rate at 4% and min at 3%, and the company can borrow at L+ X%, the exercise price for put option will be 4-X and call option will be 3-X (ALWAYS).(2) If the company can borrow at L+X%, and if the spot price at the date of transaction isn’t given, then the ‘Lock in rate’ we find will always be the ‘LIBOR’ lock in rate. We would then need to add X to find the “overall” expected lock in rate.
Am I right with both these statements?
Thank youI am afraid that the answer is no to both.
1. The exercise prices for rates of 4% and 3% would be 96 and 96.
2. There is no such thing as a ‘LIBOR’ lock-in rate.
In both cases we are hedging against charges in the fixed interest rate on borrowing or depositing between ‘now’ and the date that the borrowing or depositing starts.
Oh..So this is scarying me a little bit now 🙁
Sorry sir I dont understand how you derived 96 for (1).I’m giving you the references to both statements which I tried to justify. Since both are old questions, I’ll give you the facts and copy the relevant extract
(1) FNDC plc (Dec 06)
Facts- Company can borrow at L+ 1.25%
Question asked- Calculate the outcome of a collar hedge which would limit the maximum interest rate to 5.75%, and the minimum to 5.25%.
(These interest rates do not include any option premium.)
Extract from the solution- A maximum interest rate to the company of 5.75% implies a LIBOR rate of 4.5%, or 9550. A minimum rate of 5.25% implies LIBOR of 4.0% or 9600.(2) Interest rate Hedges (June 05)
Facts- Company can invest at L +0.6% , Today is 1 June, spot rate =4%, Invest on 31 Oct, Dec futures= 96.6
Extract from the solution- The expected LIBOR lock-in rate is = 100 – (96.60 – 0.171) = 3.571%
The company will invest in commercial paper at LIBOR + 0.60%. The overall expected
lock-in rate is 4.171%.On the basis of these two sums, I asked you whether I was correct with those 2 statements…Is it somewhere I’m going wrong?
Thank you for the assistanceAhhh….now I understand what you were getting at (although I hate learning rules unnecessarily).
Once the borrowing starts it will be at fixed interest, but they obviously don’t know in advance what the rate of interest will be because LIBOR will have changed by then.
In FNDC they want to limit the maximum interest to 5.75%. Given that they will always be paying 1.25% above LIBOR they need to limit LIBOR to 4.5%. To do this means choosing an exercise price of 100 – 4.5 = 95.50.
Similarly they want to limit the minimum interest to 5.25% which means limiting LIBOR to 5.25% – 1.25% = 4%. To do this means choosing an exercise price of 100 – 4 = 96.00.
Yes I understand why they have chosen those exercise prices.
I just hope those 2 statements makes sense now sir? (Not learning rules, but just wanted to know I’m concluding it right)
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