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What type of option would a borrower use to hedge against interest rate rises and when would it be abandoned?
A. Put option, abandon when rate rise
B. Put option, abandon when rates fall.
C. Call option, abandon when rates rise
D. Call option, abandon when rates fall.
Which is the correct ans and why?
Thank you in advance.
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A
jjchiwasa: Your answer is wrong (and please do not answer in the Ask the Tutor Forum – you are not the tutor).
The correct answer is B.
I will explain, but this can not be asked in Paper F9 – whichever book you found it in should not have it there. It is beyond the syllabus for F9.
So, do not really waste too much of your time on my explanation 🙂If interest rates rise then futures prices fall (5% interest is equivalent to a futures price of 95; 6% interest is equivalent to a futures price of 94). The futures price is 100 – interest rate.
If we are borrowing money we buy a put option. This gives us the right to sell futures at a fixed price. So…..if interest rates rise, then futures price fall. We can buy at this low price and sell at the option price to make a profit. This will compensate against the rise in the interest rate.
So…the answer to the question is B – we buy a put option. If rates rise then we will exercise the option, but if rates fall we will abandon it.
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Tutor, Y say, I should not answer, wen the facility gives me an option to answer, n this question, is never directed to the tutor, n subject to be answered by n-one who has accessibility to the facility. Since its a multiple choice, I just choose 1, n dd not want to comment further.
N as an open forum, I du appreciate, being critised, so y dd u say B iz open;
Y I say so:
Whenever we borrow money, its a put/sell option, since we pay interest; (invest is a call/buy option)
to abandon iz not 2 exercise.So to hedge is to protect against adverse conditions, adverse, in this case, is to pay more interest than expected with the company, so a rise in interest iz a risk, thus y, I choose B.
Prove me wrong, bcz m also learning, Mr Tutor
jjchiwasa:
The forum is called “Ask the Tutor”. You are not the ACCA tutor. There is another general F9 forum and you are welcome to answer there.I don’t understand the rest of your post. You originally answered A. I explained why the answer is in fact B. Your latest post says you choose B and tells me to prove you wrong! It does not make sense.
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True, I agree, A is wrong,
My apologise, borrowing alwayz give rise to put/sell, bcz we are paying interest. This is a P4, question, Interest rate futures n options
That is true (and that is exactly what I said in my first answer. You are expected to know about futures and options, but you cannot be asked for calculations.)
sir,
there are 2 or more strike rate available there where we can choose the best one. Would you please tell me how do i choose the best one.?There is not a best one (and this is not relevant for F9 anyway – in F9 you cannot be asked calculation on options. It is only in Paper P4 that you can be asked to show calculations and then to discuss).
The reason that there is no best one, is that different strike prices give different maximum interest rates (assuming we are borrowing money). However, strike prices giving a lower maximum rate will have a higher premium payable and if actual interest rates fall we will not use the option but will still have to pay the premium.
We obviously do not know in advance what will happen to the actual interest rates and therefore can never say in advance which is best – we can only discuss the outcomes.
However, again, all of this is not relevant for F9 – only for P4, and obviously is covered in detail in our lectures for Paper P4.
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