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Hi John,
In this question Lirio, the way they calculated the lock-in rate was quite different from the way you described in the lecture (your way is also the way in the textbook). They calculated the lock-in date by proportioning the 2 Future prices (using 3 months difference) instead of calculating the basis risk and prorating that basis risk (using 4 months difference). The 2 approaches will not result in same answer.
I wonder which approach I should use in exam… the approach in this question seems to be even faster than the one we describe in lecture, as there is no need to calculate basis risk. If this approach is valid, should we use it for interest rate futures hedging as well?
One more thing is with the options in this question. They did not show the scenarios where option is not exercised. I wonder in the exam, can I just assume the option is exercised (ignore the non-exercise case) and calculate the results based on exercised amount? (in case they dont give any assumption for future spot rate)
Thank you
The two approaches do give the same answer (and the examiners answer says that you could use the other way). Strictly, the way in the lecture and your textbook is the correct way.
The reason that they do not show the scenario where the options are not excercised is because the answer is showing the ‘worst’ outcome that can result. This is then the basis for the discussion. The examiner is testing that you understand how options work.
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