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Hello Mr Moffat,
Sir, kindly clarify the following,
1)What is the difference between Interest Rate guarantee and Interest Rate Options? if the difference is that IRG is an OTC transaction and Interest option is traded in which the premium is determined by market forces, much more fairer and lower compared to OTC transactions, then why would a company prefer IRG to interest option. Is there any other difference apart from this?
2)Options in risk management, is the right to buy or sell futures at a certain price. So it seems they are more correlated with interest Futures. Moreover in options there is substantial amount of premium involved compared to interest futures. Why would a company prefer Options to Futures and both of them are dealt with fixed size contract?
3) The 3 months Futures i didn’t clearly understand the concept in Interest Rate Risk Management, does it mean its the time from now upto the exercise date will take place? If this is the case in example 6 chapter 20, the current date is 13 August and the company took the september futures which is only less than 2 months?
I appreciate for taking your time going through this whole question.
Thanks
Mr Moffat, just wanted to add another a small question, during delta hedge, The shareholder is worried that there will be a drop in share price, so he would sell a call option, does selling a call option mean that the shareholder has literally sold his shares but he can buy later when the share price is low? Or maybe its completely independent on its own and any gain or loss from the call option would offset the change in the share price of his shares?
Thank you very much
It is a completely independent transaction that is intended (as you say) to hedge against (cancel) the change in the value of the shares.
Hello Mr Moffat,
Kindly needed your help regarding the above first 3 questions.
Thanks
Sorry – I missed the first three 🙂
1. Although traded options are priced ‘fairly’ due to market forces, it does not mean that they might not be able to get a better deal for an OTC option (an IRG). Also, traded options have fixed sized contracts and only certain exercise prices are available. An OTC option can be tailored exactly to what is required – you can ask the bank for an IRG for any interest rate you want, and for any amount you want. The bank will then quote a premium and it will be up to use whether or not to accept it.
2. With futures, the end result is fixed. You do not lose if interest rates go up but you do not gain if interest rates go down (assuming you are borrowing money). With options you are protected against rates going up, but you gain if interest rates go down. So options are likely to be more attractive if you think that rates will fall, but you want protection in case you are wrong. (You pay a premium certainly – it is like paying for insurance)
3. The ‘3 months’ solely relates to the way that the gain or loss on the futures is calculated. It is always calculated as though it is 3 months interest (regardless of how long the futures are held).
You really do need to watch the free lectures on interest rate risk where all the above is explained in detail, with examples.
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