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How do we decide which exercise price to use when two exercise prices are given for collars?
A collar always involves using two exercise prices – one for the call option and one for the put option.
If there are more than two exercise prices given then choose and (sensible) two of them. Questions are wanting you to prove that you understand what a collar is and the potential benefit.
Have you watched my free lectures on collars?
Could you please explain to me the question in June 2015 the question on interest rate collars?
Given that they are borrowing money, they will wish to buy a put option in order to limit the maximum interest rate payable and using a put option alone they would choose an exercise price of 96.00 because this would limit the maximum interest rate the most.
If instead the went for a collar (because this would reduce the net cost of the options), then buying a put option at 95.50 would only limit the maximum interest to 4.5% (instead of 4%) but selling a call at 96 would limit the minimum interest to 4%. As the examiners answer points out this would still be worse than simply buying a put option if the interest rates increase as expected, but if interest rates turn out to reduce then it could be worthwhile (but only if rates reduced significantly). Buying a put option at 96.00 and selling a call option at 95.50 would obviously be meaningless – it would make no sense to limit a maximum rate to 4% and a minimum rate to 4.5%.
You did not answer my question as to whether you have actually watched my free lectures on this!
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