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In this question part 1 which is related to the options I just want to clear my concept in the lecture related to interest rate futures it was told that when interest rises future price falls and vise versa
so in the solution by the examiner when interest(INT) rate increased by 0.5% he estimated future price by doing this calculation 100 – (3.8+0.5) – 0.22 but when INT rate fell by 0.5% 100 – (3.8-0.5) – 0.22 why did he subtracted 0.22 shouldn’t we add 0.22 back
What i have understood from the lecture is that when INT rate increase 0.5% it became libor 3.8+0.5=4.3% which is equal to 100 – 4.3 =95.7 so future price will fall we minus 0.22 from 95.7 which gives us 95.48 (basis risk calculation)
Where as when INT rate falls by 0.5% futures rate will increase so 3.8-0.5=3.3% – 100 = 96.7 + 0.22 is this correct approach
And lastly in the examiner solution he showed the outcome of both strike prices will in exam I have to show both of I should choose one strike price and state the assumptions of why i choose this price because in exam it will be very hard to mange time if i try to show calculation with both strike prices
And one more thing why in the question he has given current basis on march future 44 points
can you please tell me how we can use this basis point to estimate the current march future price
With regard to the adjustment by 0.22, the futures price and the equivalent for LIBOR will always move closer together over time. It is this that determines whether you add or subtract (but see last comment below).
With regard to options, although ideally you should look at all possible strike prices, there is a time problem and if you just deal with one strike price properly (and write that there are alternatives, but without calculating them) then you will certainly get most of the marks. The marks are really for proving that you know how options work.
In this question you didn’t need the current futures price because he has given the current basis and the expected basis in the future. However, where the examiner was unfair was that it was not clear whether the current futures price was higher or lower than the current LIBOR equivalent (in theory it could be either). So for this question you would have to have been given full marks whether you added or subtracted the basis (even though obviously the final answer would be different).
Thanks alot for such a brief and to the point explanation just one thing more I want to know is that I am not able to interpret theses basis point given in the question.
All I want to know is that how I can use these basis point to predict the future price although its not required but just for my understanding
And why the march basis point where given in the question whats the logic of it are the of any help????
The basis is the difference between the futures price and the equivalent LIBOR at any point in time, and we assume that it falls linearly to zero by the time the future expires.
How we use it depends on the question. If we know the current futures price and we know the current LIBOR then we know what the current basis is, and we can therefore predict what the basis will be on the date that the loan starts. If we are told what LIBOR is on the date the loan starts, we are therefore able to forecast what the futures price will be.
If we are not told what the LIBOR is on the date that the loan starts (and in practice, or course, we will have no idea what it will end up being), then we can calculate the lock-in rate by taking account of the change in the basis over the period. (I don’t know whether or not you have watched it, but there is a lecture uploaded that explains the lock-in rate.)
In this particular question the current basis is not really relevant, but that is something that is common in P4 – that not all the information in the question is relevant. Part of the testing is to check that you understand what is happening and that you therefore can sort out what is relevant what is not.
Sir I am really struggling in setting up swap hedge in this question can you please help me out because I am unable to understand examiner solution its very different from what you have told in the lecture related to interest rate swap
There are various ways you can set up the swap (all giving the same end result). I think the examiners answer makes it look a bit over-complicated.
K wants to borrow fixed. If they did borrow fixed then they would pay 5.5% (and if the counterparty were floating then they would pay L + 0.3%). So in total it would be L + 5.8%.
If they do a swap, the total will be L + 0.4% + 4.6% = L + 5%
Therefore there is a total saving to be made by swapping of 0.8% of which K gets 70%, which is 0.56%.
Therefore they will save 0.56% on what they would be paying if they did not do the swap.
So they will end up paying 5.5% – 0.56% = 4.94%
In addition they have to pay the banks charge of 0.1%
4.94% + 0.1% = 5.04%I am speechless Thanks a lot Sir you made my day
sir how you selected that K wants fixed borrowing bocz there is nothing told in the question about what K wants to do??
Because the question does not say, you needed to check first which way round would result in an overall saving. It is only if K wants fixed borrowing that a saving is possible (if it was the other way round then the cost would be higher overall rather than lower).
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