Option premium - how to do it correctly?

Llala16913y ago

Hello! I am stuck with the following and would be grateful if you help me out:
How to calculate the option premium cost - should it be like
1) "premium%*number of contracts*value of contracts*time period for which option is required" - in this way it is calculated in SA Article on Interest rate management (sept 2011)
or should it be calculated as:
2) "premium%*value of loan being hedged*time period for which option is required" - in this way it is calculated in Kaplans final assessment Q3 or past paper for Dec 06, FNDC plc
or those are different situations for which each of the formulas are applicable?
Thank you very much
Olga

John MoffatTutor13y ago#1

The first method is correct, but be careful (see below).

The point is that there are fixed sized contracts, and therefore although you want to hedge the amount of the loan, it will not be possible unless the amount divides exactly by the contract size.

Also, to get the number of contracts you take the amount of the loan, then you multiply by the length of the loan in months and divide by 3 (because the options are on three month futures).

When you calculate the premium you take the % from the tables, multiply by number of contracts, and then divide by 3 (again, because they are three months futures).
That is what Sunil has done in his article.

The way that you say that Kaplan has calculated it will give the same answer, provided that the loan divides exactly by the contract size.

Have you watched my lecture on interest rate options?