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Hi sir,
I have a question in mind. We say in collar, we either buy put options and sell call options to counterparty (vice-versa) so as to minimize the premiums that we have to incur in options. And if the counterparty exercise the options that we sell and gain, we will incur the loss.
My question is should we include the loss in our effective interest rate calculation or should we not? In real life who’s the one absorbing the loss, is it intermediary who acts as a bridge btwn us and the counterparty? Or we as a seller of the options?Many thanks sir.
Yes. The whole point of selling a call option is that it limits the minimum interest we will pay.
If the actual interest we pay is lower than the limit effectively set by the option, then although we actually pay less interest we also have to pay out to the buyer of the option – the pay out on the option ‘cancels’ the saving in the interest paid.The reason for being prepared to have a minimum interest rate is because we will receive a premium and that reduces the overall premium cost of limiting a maximum rate.
I do suggest that read my article:
https://opentuition.com/articles/p4/interest-rate-collars/Thanks sir, your article is as wonderful as you, couldnt refuse to ‘bow’ on you and the efforts you put!! ?
Having said that, can I clarify something with you so that you can correct my understanding (if I’m wrong)?
1. In your example, we buy put and sell call, effectively this reduces the premium paid by us from buying put options.
2. Despite the reduction in premium that we have to pay, we may ‘lose out’ by limiting ourselves to the minimum interest that we gotto pay ( which is limit the interest to 4% instead of benefiting from 3% market rate in your example).3. Putting 1. & 2. together can we say we MIGHT still incur loss ( in the case where 2. above is higher than 1. above), of which if this is the case it can lead to a saying that “it’s better not to use collar since we will suffer more losses as compare to the use of options as a hedging strategy”?
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