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Mike does not teach P4 🙂
Please give the name of the question (and if it is a past exam question then which date). It seems that my edition of the Kaplan kit is different from yours.
Oops.. Sorry John,
The name of the question is Collar Hedge in Kaplan(June 03 A). BPP has the same question under the name of Troder – Q.51 and it is part b(ii) that I am after.
🙂
The exercise price of 95250 (although they quote it this way often in the exam, it really means 95.250) is equivalent to a LIBOR rate of 100 – 95.250 = 4.75%
(The free lecture on options might be of help, and the extra note I have written on collars.)
Hi John,
Thank you for the response. I understand the 100-95.250, but i thought an investor would buy a call option at a floor rate and would sell put at a cap rate.
Now my question is, if an investor would buy call at a floor rate and sell put at a cap rate, why as per the answer on the book we are setting the collar at a same put and call price?
Also, the part b(i) on the same question we find different alternatives to give us a minimum interest rate of 4.05% on the investment. Why haven’t we included a same call and put strike rate on part b(i) to give us more alternatives to choose from?
I hope i am making sense??
Sorry – but all you asked before was how they came to a maximum of 4.75%, which is what I answered 🙂
Someone depositing (as in this question) will indeed buy a call option in order to set a minimum rate. If they wish to reduce the net premium payable, then they will create a collar by selling a put option and therefore fix a maximum rate.
BPP could have considered more alternatives, but this was not required in the question. The question asked to illustrate how a collar hedge could be used (and they have done this). It then asked what the maximum interest was for the hedge that you had selected.
It did not ask you consider all possibilities and advise as to which was best.
Thank John, but why have they used the same call and put price to give us 4.75% when clearly, the call option price needs to be higher to that of put option?
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