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Hello sir..
I wanted to ask that how do we choose that which exercise price we’ll use in options? In your examples, the question already states the strike price. But if it doesn’t, which price are we going to use?
As far as my knowledge is, we decide this in currency options by the amount we are going to receive after netting the premium. Is it correct?
But in IRO, how will we decide which strike price to use?Plus in dec 2008 Q5, the co. wants to keep the max borrowing rate at or below 6.6%. The strike prices given are:
93750, 94000, 94250. In the answer 94000 is chosen. Why?In the same ques, the kaplan kit’s answer says, ‘when the open and settlement prices are both quoted, it is the settlement price which is relevant as the price at which we INITIALLY BUY/ SELL the future contracts.’
But in your lectures you said that, Open is the Buy rate of futures and Settlement is the Sell rate of futures.
Kindly clear this confusion. Thank You!The main thing when doing an options question is that you can prove that you know how they work – there is not necessarily a ‘best’ option price to use.
In this question, they want to keep the borrowing rate below 6.6%. The company pays a premium of 0.50% and so they want to protect against LIBOR being above 6.1%. Choosing a strike price of 94.00 is equivalent to 6%, but there is also the premium payable of 0.168% which would limit the rate to 6.168% (ignoring basis risk).
If we chose as strike of 94.25, this would limit to 5.75% plus the premium payable of 0.3% which is 6.05%. A ‘better’ limit, but of course a bigger premium payable even if the option were not used. You would get the marks in the exam whichever of the two you considered.
With regard to open and settlement, I do not remember ever mentioning the words in my lecture (I must check and correct it if I did). This is the only question where the words have been mentioned (it was the previous examiner). Open is the price at the start of the day, and setllement the price at the end of the day. Kaplan are correct to say that we always use the settlement price as the price at the start of the futures deal.
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